EIOPA's draft response to the EC on Solvency II

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The consultation issued by EIOPA, on its draft response to the EC’s questions about how Solvency II can be amended to apply to pension schemes, closed on 2 January 2012. EIOPA had been asked for advice on how to meet the EC’s objectives of simplifying setting up cross border schemes, modernising the prudential regulation of defined contribution schemes and enabling IORPs to take advantage of risk mitigation techniques. A key procedural objective for the EC is for a consistent regulatory structure to apply across the financial services sector, and it believes this can be achieved by adapting the principles underlying Solvency II for pension schemes.

Consequently, in its draft response, EIOPA has taken Solvency II as the framework for regulating all pension schemes within the scope of a revised IORP Directive (IORP II). Some aspects of Solvency II are likely to make IORP II more effective, if adapted to reflect the different legal structures and risk characteristics found in pension provision throughout the EU. However, a wholesale adoption of the requirements to finance reserves to the levels expected of insurance companies does not seem practical, particularly without a long transition period.

In fact, although the consultation goes into considerable detail on how IORPs should measure their assets and liabilities, including sections on establishing solvency capital requirements (SCR), it is relatively silent on how a stronger measure of the liabilities and the SCR should be financed. Thus, an innocent take-away from the document could be that all EIOPA is proposing to the EC is that IORPs should have information similar to that provided to insurance companies under Solvency II, to enable them to understand the risks they face and to support the development of more thoughtful risk management policies. By that measure, there is no proposal that a stronger liability measure should actually be financed, other than perhaps notionally, using ‘virtual’ assets such as employer covenant and statutory guarantee funds.

The ‘holistic balance sheet’ proposal, suggesting IORPs should consider how they rely on employer covenant and other forms of contingent assets to contribute towards member security, particularly in the context of unmatched investment strategies, could be interpreted consistently with this view.

More realistically, EIOPA has only refrained from discussing the financial consequences of its proposals on IORPs and their sponsoring employers because this is, ultimately, a political issue. Since the EC thinks that it will achieve ‘consistency’ between financial services sector via the revised Directive, the presumption must be that the strengthened liability equation will have to be matched somehow by a stronger funding regime. However, there are two objections, at least, to this:

First, the desire for ‘consistency’ is misplaced. Most importantly, as the consultation acknowledges, IORPs are not the same as insurance companies: for example, they cannot raise capital on financial markets to finance their liabilities, since their sole source of income is the sponsoring employer and their ability to make payments other than to scheme members is limited.

If a pension scheme is underfunded, and supervisory authorities require it to rectify this, the choices available to an IORP are to reduce benefits or to demand additional contributions from its employers. But payment of these contributions remains largely voluntary (except sometimes in extremis), and companies will have to balance this request against other, possibly prior, demands on their cash flows. If the principle of voluntarism is removed, particularly in relation to past accrual, then pension regulators effectively have carte blanche to interfere in areas of company and contract law, potentially upsetting banking covenants and borrowing costs: since EIOPA is part of Europe’s system of financial supervision, including banking supervision, it seems unlikely that this is the result that is sought.

Secondly, it is, in any case, misleading to assume that applying Solvency II will achieve ‘consistency’, since many pension schemes remain outside the scope of the IORP Directive. For example, the consultation leaves pay-as-you-go and book reserve schemes outside the new regulatory regime, even though they might in fact be partially funded; while funded schemes will be subject to its full force, (even though they, also, might be only partially funded).

Other aspects of the consultation are likely to be less controversial. The immediate concerns in relation to regulating IORPs have arisen largely in the context of the increase in defined contribution arrangements. The existing IORP Directive does not impose any special requirement on these, so ignores the very different risk profile they place on members, relative to defined benefit provision, and the additional information and governance requirements on IORPs that might be needed as a result.

Solvency II, on the other hand, is explicit about the steps insurance companies need to take to demonstrate that they operate transparently and act responsibly. EIOPA has consulted on combining these principles with the communication requirements in the UCITS Directive (which applies to collective investment schemes, like unit trusts), which would mean IORPs would have to provide members with information about the arrangements for making contributions, including describing the investment choices available and their different risk structures, and any charges imposed. This could contribute to a stronger regulatory regime that should provide better outcomes for defined contribution members, although providing information does not necessarily mean that members are able to make informed choices.

There are other proposed measures in relation to IORPs generally, that it should be easy to reach a consensus on. These include:

• Strengthening the bodies in IORPs that are responsible for decision making, to ensure they are independent and have robust internal controls;
• Being more explicit about the general levels of competence and governance expected from IORPs’ managers; and
• Adopting more considered approaches to risk management, to ensure that uncertainties due to investment strategy and benefit structure are understood.

It is true that IORPs’ standards of governance vary throughout the EU. However, often the cost of governance models in different member states reflects the risks faced by scheme members. The benefits provided by IORPs in scope of the Directive are generally supplemental to state scheme benefits. In some cases, they contribute only a relatively small amount of an individual’s retirement income and so a burdensome regulatory regime might be disproportionate.

The EC has set a very tight timetable for its review of the IORP Directive, suggesting that a draft of IORP II could be ready for consultation before the end of 2012. This might be a reasonable target with respect to many of the proposals, but far more clarity is needed about the financial aspects of the proposed changes before they can be transposed into a directive.