Dirk Broeders, Niels Kortleve, Antoon Pelsser and Jan-Willem Wijckmans assess EIOPA’s holistic balance sheet proposal

The European Commission has put forward the aspiration to further harmonise pension supervision on a European level. This requires a review of the current IORP Directive. In a new directive, the Commission wants to expand supervision to all member states, to encourage cross-border activity and to introduce risk-based supervision.

In April 2011, the Commission issued a call for advice asking the European Insurance and Occupational Pensions Authority (EIOPA) how to achieve this goal. On 15 February 2012 it proposed the concept of a ‘holistic balance sheet’ (HBS) as the way forward to achieve as much harmonisation as possible in pension supervision.

An HBS recognises the steering instruments that distinguish pension funds from insurance companies. Although the underlying principles of Solvency II may be useful, both the Commission and EIOPA have stated that Solvency II is not applicable to pension funds. Commissioner Barnier stated on 10 February 2012 that “we will inspire ourselves from the Solvency II approach when appropriate but that does not mean we will ‘copy and paste’ Solvency II”, and he repeated that statement in the Commission’s public hearing on 1 March.

We endorse the statement that pension schemes differ from other financial contracts and therefore require a tailor-made supervisory regime. We propose a supervisory framework for all different occupational pension systems throughout the European Union that is consistent in the methods and instruments being used, but that is still tailored to the specific characteristics of each individual pension system.

Our proposal starts by clustering pension schemes along three dimensions, and we discuss the various supervisory instruments that can be used for each cluster in order to achieve the goals of supervision in a consistent manner. Our recommendation is that, after further research and quantitative impact studies, an HBS approach could possibly be first introduced for designated pension funds. Since the calculation of an HBS is a complex and time-consuming effort, it could help the introduction of the HBS approach if this would actually lead to a better insight in the risk profile of the pension fund and, therefore, better risk management.

In the remainder of this article, first, we review briefly the goals of supervision. Second, we map the wide variety of pension schemes and applicable supervisory instruments and third, we discuss the strengths and weaknesses of the holistic balance sheet approach.

Goals of supervision
The key objective of pension fund supervision is to make sure that reasonable policyholders’ expectations are being fulfilled by the pension fund. The main question in assessing this is also to what extent are the contribution policy, investment policy, sponsor commitments, and funding position of the pension fund in line with the benefits and risks communicated to all stakeholders in the pension fund? To meet this objective, the supervisory authority needs to assess four key areas of attention of the pension scheme and the pension institution: financial health, risk management, disclosure, and governance. A prerequisite for good supervision is that the right information is provided and analysed. This assessment may lead to different levels of corrective action.

A wide variety of pension schemes
Specific to pension supervision is that pension schemes differ from other financial contracts and therefore require a tailor-made supervisory regime. The beneficiaries do not only have a senior debt claim on the pension fund but are often also the residual claimant. Furthermore, pension funds differ from insurance companies through institutional design, different means of funding, possibilities for risk sharing and more flexibility (see Kortleve et al., 2011).

Across the European Union a wide variety of pension systems exist. However, to organise harmonised supervision it will be advantageous to classify these systems. They can, for example, be characterised along the following three dimensions:

• The pension benefit: guaranteed payouts versus non-guaranteed payouts.
• The method of financing: funding versus pay-as-you-go.
• The level of risk sharing: no risk sharing versus risk sharing among multiple stakeholders.

The stakeholders that may be involved in sharing risk (in the third dimension) are the sponsor, active generations, retirees, deferred members and future members.

These three dimensions lead to eight possible types of pension schemes (see Broeders et al., 2012 for a more detailed description). For each cluster we offer one familiar example in the bottom row in figure 1.

Different supervisory instruments
After the clustering of pension schemes, we discuss the impact on different supervisory instruments. The most widely used form of supervision of financial institutions involves quantitative requirements. These rule-based instruments are both effective and simple. They allow red flags to be placed, usually without the need of additional judgment or interpretation. We see the following quantitative instruments: capital requirements; continuity analysis; stress test; recovery plan; and also the HBS approach. Figure 2 maps the quantitative instruments on the various types of pension schemes and one immediately observes that not all instruments are applicable in all situations.

From the figure, one can read that, except for the continuity analysis and stress tests, not all instruments are always highly applicable. Capital requirements and the HBS approach are typically highly useful instruments for DB and DC with guarantees, and collective DC schemes (a scheme with collective risk sharing).

Next to quantitative instruments, we also see an important role for qualitative instruments in supervision. These comprise supervisory assessment on governance, supervisory assessment on risk management, self-assessment (like the own risk and solvency assessment for insurers) and disclosure requirements. For brevity reasons, we will not discuss those here (for more details see Broeders et al., 2012) and, instead, focus more in-depth on the HBS approach.

HBS needs to mature
EIOPA brought forward the concept of an HBS in its reply to the call for advice on 15 February 2012 (EIOPA, 2012). The idea behind it is that the pension fund’s specific steering instruments are recognised and included in the balance sheet. After all, the security of pension benefits can come (partly) from contingent assets like extra contributions, subordinated loans, or a sponsor covenant. The HBS approach is typically useful for funded schemes, with at least either some form of guarantee or multi-stakeholder risk-sharing. An HBS approach offers various advantages:

• Incorporation of all steering instruments in assessing the solvency of pension schemes.
• Enhanced comparison between different pension schemes.
• Increased discipline and professional risk management.
• Improved transparency.
Although an HBS has many advantages, we also see challenges as it is a fairly new concept:
• Valuation: The valuation of contingent balance sheet items may prove to be complex, requiring option-valuation techniques, modelling for incomplete markets, making assessment/judgments, etc. (see Broeders et al., 2012).
• Proportionality: pension rules should not be vastly disproportionate for small pension funds leading to high supervisory costs and a burden on the trustees.
• Pseudo-security: the calculation of the HBS will ask for considerable judgment, leading to an accumulation of assumptions and therefore model and parameter uncertainties.
• Completeness: The full valuation of all steering instruments requires the pension deal to be complete, which is usually not the case. In other words, making trustee decisions on contributions, pensions, indexation, etc, on an ex-ante rather than ex-post basis, leaving less discretionary freedom for trustees.
• Applicability: The HBS is not useful for non-funded schemes and for individual DC contracts without guarantees.

EIOPA is currently working on a quantitative impact study (QIS) for the HBS. Gabriël Bernardino, chairman of EIOPA, stated in January that the pension sector should not try to kill the concept of an HBS before one, or preferably more, QIS has been undertaken - “Don’t kill the baby before it can walk”. At the same time, we suggest that EIOPA should let the balance-sheet approach mature in full before making it a key supervisory instrument - Don’t make the baby walk the walk before it can talk the talk. The HBS may not yet prove to be the holy grail of supervision.

We see three steps before the introduction of the HBS as a mainstream supervisory instrument can be considered:

1. Having the European Commission and EIOPA conduct impact assessments and quantitative impact studies, in order to gain more insight into the impact the method has for pension funds.

2. Start testing with the HBS approach in close cooperation with several designated pension funds, covering the various types of pension schemes, before introducing the method to all pension funds.

3. The method could first be introduced as an internal model. This may prove to be an effective way to further develop the HBS approach and stimulate acceptance across the pension sector.

Pension schemes are in many ways different from other financial contracts. The beneficiaries do not only have a senior debt claim but are often also the residual claimant of the pension fund. Furthermore, pension schemes can be financed in different ways and pension funds typically have more control options to manage the balance between assets and liabilities. The differences should reflect in the supervisory framework.

Pension schemes are also mutually different along three dimensions: the type of benefits (the existence of guarantees), the method of financing and the level of risk sharing. Therefore, supervisors need a toolbox of various supervisory instruments, both quantitative and qualitative. Their application is dependent on the benefit structure and the supervision should be appropriate, given the type of benefits. Quantitative instruments like capital requirements and an HBS approach are typically highly useful instruments for DB contracts and DC contracts with guarantees, whereas qualitative instruments are always applicable.

The HBS approach has advantages but also offers some challenges. It needs more research, as well as impact assessments and quantitative impact studies before it can be mature enough to be widely used as a supervisory instrument. Given its complexity, proportionality is also an issue for the application can be too intense (expensive) for small schemes, another reason to research other supervisory instruments as well.

Dirk Broeders, Niels Kortleve, Antoon Pelsser and Jan-Willem Wijckmans (2012), ‘The design of European supervision of pension funds’, Design paper 6, Netspar, February 2012.

EIOPA (2012), ‘EIOPA’s Advice to the European Commission on the review of the IORP Directive 2003/41/EC’, www.eiopa.europa.eu, February 2012.

Niels Kortleve, Wilfried Mulder and Antoon Pelsser (2011), ‘European supervision of pension funds: scope, purpose and design’, Design paper 4, Netspar, October 2011.
Dirk Broeders is senior strategy adviser in the supervisory policy division at DNB; Niels Kortleve is innovation manager at PGGM; Antoon Pelsser is professor of finance and actuarial science at the University of Maastricht and Jan-Willem Wijckmans is strategic risk manager at PGGM