Pension funds are broadly against Solvency II. Yet the EC is still assessing whether parts of it might apply to pension funds through a new IORP Directive, writes Nina Röhrbein

European pension funds do not directly fall under the Solvency II Directive. However, the European Commission (EC) is currently revising the Institutional for Occupational Retirement Provision (IORP) Directive, and is looking at parts of Solvency II to see whether and how they should be adapted to apply to pension funds.

The original aim of the IORP Directive was to facilitate cross-border activity, and this requires a minimum level of convergence regarding prudential regulation.

Last April the EC issued a call for advice to the European Insurance and Occupational Pensions Authority (EIOPA) on its review of the IORP Directive. EIOPA’s 500-page response was open for comments until 2 January this year.

The EC accepts the differences between insurance and occupational pensions, in particular of the sponsor’s role in making up deficits. Nevertheless it noted that EIOPA’s advice should “endeavour to maintain consistency across economic sectors”.

One of EIOPA’s proposals is to take into account the sponsor promise as an asset similar to reinsurance, which it terms the “holistic balance sheet”. Another is that supervisors should consider the potential impact of their decisions on the stability of the financial systems and to take into account the potential pro-cyclical effects of their actions in case of extreme stress”.

The European Federation for Retirement Provision (EFRP) is one of many bodies that have come out against applying Solvency II-type rules to IORP. Its main argument is that because pension funds are different from insurers they require a different regulatory approach.

Many European occupational schemes, for example, are industry-owned, non-profit pension funds which employers are obliged by law to fund and therefore object to the possibility of being subjected to the same capital requirements as commercial pension providers.

Insurance companies do play an important role by affording people the flexibility to top-up collective retirement provision under the first and second pillar, according to the EFRP and they also administer occupational pensions. But Solvency II imposes the so-called solvency capital requirement (SCR) on insurers; the SCR aims to reduce the probability of insolvency within one year to 0.5%.

Pension funds fear they could lose their freedom of investment choice if European regulators use the Solvency II capital rules as a model for pension funds. They would have to build up large buffers or lower the risk profile of their investment portfolio - in other words, reduce their share of riskier asset classes such as equities and alternative investments.

Pension funds also worry that strict solvency rules would will create systemic risks, have cyclical effects and increase costs for employers.

“Solvency II is based on the logic that built-up capital is enough to make an institution robust,” says Chris Verhaegen, former EFRP secretary general and chair of EIOPA’s occupational pensions stakeholders’ group. “But this is not true for pension funds. Even the governance rules of Solvency II are made for large, complex institutions. We need something more suited to the nature of pension funds, which is why we believe that Solvency II cannot be used as a starting point for reviewing the IORP Directive.”

Pension funds across Europe will be affected differently under Solvency II rules. Funds in Scandinavia - Denmark, Norway and Sweden - are ruled by insurance legislation, so Solvency II would apply to them. Danish legislation, for example, is already being gradually adjusted to Solvency II, although the basic principle of risk-based supervision was already present in Danish regulation.

Besides the capital guarantee, the administrative burden for pension companies in relation to corporate governance and management will also increase. As a result, Danish pension funds will have to lower their guaranteed interest rates, change them to declarations of intent, or even consolidate with other pension companies.

For the few pension funds in France, such as third-pillar voluntary schemes, the introduction of Solvency II is a challenge. France - with its life-insurance culture alien to pension funds - did not adopt the IORP Directive into national law, and thus pensions are viewed as an insurance matter.

According to one pension fund, there are still four possible outcomes for funds in France: the IORP Directive could be integrated into French law to avoid the application of Solvency II to pension funds; the money required to continue operating the scheme could be borrowed; the scheme could move to another European country; or it could stop operating and return all the capital to the members.

Pensionskassen in Germany could also fall under Solvency II legislation. However, forcing German occupational pension funds to comply with Solvency II risks weakening the system due to the increase in capital requirements, Towers Watson has warned. It argues that occupational pensions (bAV) are already doubly insured in the German system, with the employer stepping in should either Pensionskasse or Pensionsfonds be unable to cover the pension promise and the assurance of insolvency fund PSV on top.

In the UK, schemes could be affected by rising annuity prices as a result of Solvency II, and retiring defined contribution scheme members who have to buy annuities will get less retirement income for their money. According to Towers Watson, there will potentially be changes in the investment behaviour of insurers which, because of their market share, will have knock-on effects for pension schemes.

For schemes looking to buy out or buy-in, there is a risk that, on current pricing terms, annuities will become a less attractive product for insurers, says the consultancy.

Others fear that strict Solvency rules could substantially increase employer liabilities for defined benefit (DB) schemes, thereby accelerating the demise of such schemes, leading to overall lower pensions. How Solvency II’s governance requirements would translate into a revised governance framework for UK schemes is unclear.

However, Solvency II is not all bad news for pension funds. Some market participants say that pension schemes will benefit from more secure annuity contracts. And if pillars two and three of Solvency II are suitably adapted this could create a good risk-based regulatory framework for DB schemes.

In the wait for a definite proposal for a new IORP Directive, Verhaegen believes it is difficult for pension funds to prepare.

“Of course, pension funds will think about the lowest capital requirements that may be imposed upon them,” she says. “But from a macro-economic and pension fund point of view, that is detrimental because risk-free investments, which help to keep down capital requirements, will not allow schemes to generate any significant performance that would allow them to index the pensions.”