Would Europe’s pension funds be able to withstand a sudden reversal in asset prices, with the stock spreading across all developed nations? That is one of the questions now being investigated by the European Insurance and Occupational Pensions Authority (EIOPA) as it launches its contentious stress tests of the sector.

Covering 17 countries across the European Economic Area and targeting both defined benefit (DB) and defined contribution (DC) funds, the exercise aims to generate the kind of data supervisors already possess for the insurance sector. Gabriel Bernardino, chair of EIOPA, says he accepts pension funds are already exposed to the challenging environment of rising longevity and the “key vulnerability” of falling interest rates, but the risk of the market re-pricing itself also needs to be assessed.

While DB funds will be asked to assess the impact of two market scenarios on funding (see Stress test scenarios), DC funds will be asked to say how the scenarios would affect the retirement income of members five, 20 and 35 years from retirement. Unlike with DB funds, the DC section will not assess plan stability but rather the impact of both scenarios on replacement rates, as well as how well designed the various systems are, with their ability to deliver on retirement income after shocks.

The results would also allow the supervisor to chart how market shocks would ripple across the continent, with the exercise covering any pension systems with more than €500m in assets. 

Accepting that pension funds are not the same as insurance providers, EIOPA set out to differentiate its assessment from those previously conducted for insurers. It will therefore strive to take account of any protection mechanisms and the ability of plan sponsors to absorb losses – or for benefits to be reduced, as is possible in Ireland and the Netherlands. 

Stress test scenarios

Scenario 1: Negative demand shock
A broad-base reversal in asset prices across all developed economies and major asset classes, resulting in further problems for EU sovereign funding and bank lending. The spread between German sovereign yields and other EU countries widens on the back of country-specific problems, with consumption falling and unemployment rising. 

Scenario 2: Negative demand and supply shock
An abrupt decline in asset prices, coupled with geopolitical risks that lead to an oil and commodity shock that did not occur as part of scenario 1. The declining oil price is assumed to compensate for the drop in demand, with the US less affected than the EU due to its status as a large oil producer and its more advanced economic recovery. 

National supervisors have been briefing local pension funds on how to deal with the labour-intensive exercise, which will conclude in August when local IORPs submit their data. Next year EIOPA will pass the results of this and a separate quantitative assessment (QA) to the European Commission. 

As if the stress test were not controversial enough, the QA is raising eyebrows by asking pension funds to assess the impact of the holistic balance sheet (HBS) on the sector’s solvency. EIOPA argues it is seeking to minimise the administrative burden for the sector by conducting both studies at the same time, but critics question whether the supervisor even has the authority to continue with investigations that will feed into work on the HBS, regarded as a relic from the previous Commission’s attempts to put pension regulation on similar footing to that of the insurance sector. 

 The QA will seek to assess how pension funds would be affected by a shift to a risk-free discount rate “similar to those provided for the long-term liabilities of insurance undertakings” in line with Solvency II. The assessment will also see pension funds conduct calculations for solvency capital requirements for four key risks – operational, market, counterparty default and pension liability – in line with the insurance sector’s regulation, requiring a 99.5% confidence level.

 The supervisor notes that it is offering the QA advice voluntarily, not at the behest of the Commission, with the assessment offering a more up-to-date picture of its six HBS proposals published last October. At the time, the industry was hopeful EIOPA would consider a grandfather clause that would only see future accrual covered by the new regime, and it was urged to decide whether there would be an exemption before proceeding further.

 However, the QA consultation avoids giving any firm a guarantee of grandfathering, and it did not offer any suggestions as to how grandfathering could be implemented.

 “EIOPA acknowledges that there might be a need for such measures, if a harmonised risk-based prudential framework based on the holistic balance sheet was introduced,” it says. “But the design of such measures will depend to a large extent on the choices made with regard to the implementation of such a framework.”

 In line with its previous approach, the QA, unlike the stress test, will not cover pure DC schemes but the HBS would still risk capturing many of Europe’s largest markets, as funds offering an element of investment guarantee could be considered DC.

EIOPA will offer its advice, once completed, to the Commission. The industry remains concerned the data will be used to justify any future solvency requirements, even if the current Commission has made plain it is no longer interested in pursuing Michel Barnier’s project of levelling the playing field between insurance and pensions.  

What does the industry make of EIOPA’s stress test plans?

Matti Leppa¨la¨

Matti Leppälä, secretary general, PensionsEurope

“Why does EIOPA need to stress test the holistic balance sheet, which does not exist yet and has not been approved by anybody? This stress test will give just a snapshot picture. It does not enable the long-term evaluation of the sustainability of the IORP.” 

Jerry Moriarty

Jerry Moriarty, chief executive, Irish Association of Pension Funds

“Like most people in the pensions industry, we struggle to see why EIOPA is proceeding with the stress tests, since the European Commission has taken the issue of solvency away from the IORP review that’s currently taking place.” 

Falco Valkenburg

Falco Valkenburg, chair of the pensions committee at the Actuarial Association of Europe

“The discount rate is very important in EIOPA’s discussions on the HBS, and two types of discount rates are debated: a risk-free rate or a rate based on the expected return on assets. But it is not a choice between the two extremes. The discount rate should reflect the nature of the pension deal depending on guarantees, sponsor support, etc.” 

James Walsh

James Walsh, EU and international policy lead, National Association of Pension Funds

“It’s a shame EIOPA is pressing ahead with this exercise – we regret the decision. EIOPA could find much more productive ways to use resources, as we have much larger problems in pensions right now.” 

Heribert Karch

Heribert Karch, chairman, German pension fund association

“EIOPA has no legal basis for the new phase of stress tests. The European Commission’s thoughts have moved on, and EIOPA continues the job begun by Commissioner Barnier. How can this be true? I have to ask: how long will we continue to put up with this?”