While the UK's pension provision regime embraces some objectives of the Solvency II framework, it is not appropriate for the country's schemes, argues Sam Hall  

In July 2007, the European Commission published its proposal for the introduction of a new solvency framework, Solvency II. This framework looks to achieve several objectives. These are: enhancing protection for individual insurance policyholders; modernising supervisory bodies; avoiding significant market disruptions caused by adverse events; and developing a more competitive EU insurance market.

The basic idea is that insurers should focus on the active identification, measurement and management of risks. To accomplish these objectives, this policy seeks to ensure companies maintain sufficient levels of capital resources, while promoting higher quality risk management.

The framework of Solvency II follows a similar structure to that of the Basel II banking framework with the use of a three-pillar system. Pillar I covers the calculations and modelling of the capital requirements, with the goal of finding a harmonised method of valuing assets and liabilities. This pillar is quantitative in nature and looks to adequately assess a firm's capital requirements based on its individual risk characteristics.

Pillar II covers the supervisory review process, which aims to ensure that companies are able to manage and monitor their risks efficiently, while building stronger relationships between supervisors and companies.

Pillar III covers market discipline and disclosure, which fundamentally deals with the public disclosure of financial information by companies.

Although a press release from the Commission has said that Solvency II will not apply to pension funds covered by the occupational pensions scheme directive (the IORPS Directive), there is a debate across Europe as to whether the rules should be extended to cover pension schemes.

In the UK, occupational pension provision already has similarities to the three-pillar approach. The scheme funding regime, introduced by the Pensions Act 2004, sets out how a scheme should be funded. The Pensions Regulator acts as the supervisory body in ensuring that schemes comply with this regime and schemes are required to provide annual funding statements to keep members informed about how securely their benefits are being financed.

While the existing legislation seems to satisfy the second and third pillars of the Solvency II framework, the quantitative analysis covered under pillar I would result in a significant change in the way in which the assets and liabilities of UK pension schemes are valued and would have significant consequences for the future of UK defined benefit (DB) provision.

Under the scheme funding regime, a pension scheme is required to have sufficient assets to meet its technical provisions. These should represent a ‘prudent' estimate of the provision needed to meet benefit payments and are also expected to take the investment strategy of the scheme into account and include margins to allow for adverse experience. Any shortfall in assets revealed at the scheme's triennial valuation should be made up over as short a time period as the employer can reasonably afford. The average recovery period adopted in the UK is around 6.5 years.   

While the bases adopted by schemes can vary considerably, the rate used to discount the projected cash flows is usually derived by reference to either gilt yields or corporate bond yields, with an addition to allow for outperformance relative to these from other asset classes held by the scheme. 

In contrast, under pillar I of Solvency II an insurance firm is required to calculate its technical provisions by discounting each future cash flow using an appropriate risk-free rate. If pension schemes were forced to discount their liabilities using the risk-free rate (in other words, gilt or swap yields) this could increase a scheme's technical provisions on average by at least 20%.

Allowing for a reduction in funding levels driven by the recent fall in equity markets, changes in bond yields and increasing inflation expectations, adopting a gilt yield basis would result in an aggregate funding deficit of around £180bn (€228bn) for FTSE350 companies as at 30 June 2008. This would require cash injections equivalent to around 4% of the total FTSE350 market cap in order to restore full funding on a gilt basis over a one-year period. 

Furthermore, under pillar I of Solvency II, insurers are required to hold sufficient assets to be able to meet their obligations even in the type of adverse economic scenarios that might be expected only once in every 200 years. Applying this approach to pension schemes would therefore require schemes to hold sufficient assets such that the scheme remains fully funded on a gilt basis with a probability of 99.5%. 

The majority of UK schemes have historically invested a large proportion of their assets in equities, as this asset class is expected to achieve higher returns over the long term than investment in risk-free assets such as gilts. While retaining equity investment may remain a viable option when considering the consequences on funding over a longer time period, turbulence in equity markets and the poor match between an equity asset and a pension liability would have severe consequences on funding over the short term.

In addition, schemes face other risks which, under a Solvency II-type regime, they would be required to hold a reserve to protect against, for example, adverse movements in interest rates, inflation expectations and longevity improvements. 

For the FTSE350 schemes which still retain on average around 50% in equities, support-ed by the existence of the sponsor covenant, the requirement to hold sufficient assets to remain fully funded on a gilt basis with a 99.5% probability could require a solvency buffer of around a further 30% of their combined technical provisions. This translates to a further capital injection of £180bn.

A requirement to fully fund the liabilities on a risk-free basis and hold a buffer would remove the incentive to hold equities for
most employers. One would expect an accelerated shift from investing in equities towards less risky assets such as bonds and other fixed yield securities in order to reduce the solvency capital requirements. One would also expect schemes to improve the duration matching of their assets and liabilities through the use of derivative instruments to protect against adverse movements in interest and inflation rates.

These two trends have been seen in the Dutch pension system after the introduction of the Financieël Toetsingskader (FTK) in 2007. This is similar to the Solvency II framework in terms of defining solvency capital requirements based on the risk profile of pension funds, albeit the actual capital requirements are much lower, with a 97.5% (1 in 40) confidence level versus 99.5% (1 in 200). 

Since some firms are already struggling to pay off current funding deficits, a switch to a Solvency II-type regime would force some of them into insolvency and create financial difficulties for those that can currently afford their DB provision. This would put further pressure on the Pension Protection Fund (PPF), which is likely to struggle to meet the required solvency margin. The result could be increased levy payments for those schemes that survive the change in regime.

The significant rise in the cost of future defined benefit pension provision is also likely to result in those employers that have so far resisted this step being forced to close their schemes to future accrual.  

So what is the likely future impact for UK schemes? A look at the objectives of Solvency II shows that the current form of pension provision in the UK either satisfies these to a large extent or is not directly relevant:

Enhancing policyholder protection - while higher capital requirements may be appropriate for insured pension provision, UK occupational DB schemes are governed under trust law and the existence of the sponsor covenant and the Pension Protection Fund provide additional guarantees to members.

Modernising supervisory bodies - the introduction of the Pensions Regulator with powers to issue contributions notices and financial support directions to companies has brought a vast improvement in this area.

Avoiding significant market disruptions caused by adverse events - the introduction of Solvency II to UK occupational schemes could result in a sell-off of UK equities which in itself could cause share prices to fall further and have a negative impact on the economy.

Developing a more competitive EU insurance market - there is no competitive issue within UK defined benefit schemes since membership is restricted to employees of the sponsoring company.

While there is still ongoing debate on whether Solvency II should apply to pension schemes in order to create a level EU playing field, it appears that this is not entirely appropriate for UK occupational pension provision. Those in favour of such an approach are from countries where DB occupational pension provision is small relative to state provision and therefore the consequences for those countries are minimal.

Sam Hall is a principal within Mercer's financial strategy group