Europe’s economic turmoil is depressing defined benefit (DB) pension funding levels as yields drop and coverage ratios move in tandem.The fall in the 30-year euro swap rate from 2.54% to 2.19% between 25 Apr and 15 May makes certain that rights cuts will have to take place at Dutch pension funds, which have little hope of recovery in the short term. UK pension funding levels, and those in other countries, have also moved south, with implications for asset allocation and policy making.

Underfunding means one of two things has to happen - either liabilities must shrink (through benefit cuts, for example) or assets have to grow, either through higher contributions or investment growth.

This is a difficult balance at a time of heightened economic stress and a problematic area for trustees, sponsors, politicians and supervisors alike. Pensioners, who generally vote in greater numbers than younger citizens, do not take kindly to having their entitlements cut.

Younger participants matter too, so changes ideally need to be well balanced between generations. This means that the tendency towards pension security (reflected in asset allocation through lower yielding assets) must be broadly weighed against long-term asset growth in the interest of active members. In other words, there needs to be some level of risk embedded in the system for it to function in the longer term and to adequately meet the needs of different groups.

The plight of Greece brings home the simple economic fact that prolonged recession hurts a heavily indebted country, as the absolute level of debt stays static or grows as a proportion of static or shrinking GDP. Similarly, the imposition of harsh recovery plans forcing pension funds into low yielding ‘low-risk’ assets means that the assets cannot grow and the scheme remains underfunded.

But there also needs to be a balance between the approach of US state pension plans - which aim to meet funding targets through aggressive allocations to risk assets like equities - using high return assumptions and correspondingly high discount rates against liabilities, which masks the true extent of the liabilities over time.

In the UK, the Pensions Regulator is walking a tightrope; if it imposes too onerous funding conditions on sponsors it would push many into bankruptcy, thereby socialising the liabilities among a dwindling number of solvent sponsors. Arguably the only approach open to it - the one it has chosen - is to prolong recovery periods.

This all casts doubt on the reality of the grand plan of the European Commission for EIOPA to become the federal supervisor of Dutch and UK DB pensions, along with those in Ireland and a few other countries for good measure. National supervisors would be downgraded to an implementation role for a ‘Solvency for Pensions’ regime along with the holistic balance sheet (HBS) proposal that, the industry fears, would impose an excessive capital charge on the risk assets pension funds will need to meet long-term liabilities.

Delays in implementation of Solvency II, as well as delays in the assessment of the HBS proposals, mean EU DB pensions are off the hook for now. And if low funding levels persist, the pragmatic response to Europe’s eventual pension funding rules will be longer recovery periods - precisely the approach adopted in the UK.

Financial turmoil also focuses attention on the models underpinning Solvency II, and Brussels’ policy makers will, sooner or later, have to accept that the 99.5% certainty level of Solvency II, based on VAR, rests on dangerously weak foundations. The concept of a ‘risk-free’ government rate is also meaningless in the Europe of 2012, as is a funding standard that cannot identify ex ante that Greek debt is far from risk-free because it rests entirely on assumptions based on hindsight. The sooner we extract this legacy software from our regulation the better.