A new system of supervision that dovetails better with a pension fund’s overall risk management position is needed, according to the Pensioen & VerzekeringsKamer (PVK). In its ‘Basic principles for a financial testing framework’(FTK), it says that current supervision methods are inadequate for both pension funds and insurance companies.
Pension funds must always be able to meet their liabilities to participants, both current and former. The approach is to enable solvency to be more precisely geared to a fund’s risk profile.
The most important aspect is the adequacy test to determine if the fund has been prudent enough in determining both its technical provisions and solvency requirements. The PVK says its vision is based on the correlation between the liabilities and the assets backing these. By observing the correlation, “the real risk profile of an institution can be established and translated into the required level of solvency”.
The available funds should guarantee continuity and the supervisor will benchmark the financial norm for continuity against the norms chosen by the fund for its own policy. Three ‘continuity tests’ will used to determine adequacy over different time horizons. The continuity test of solvency development is a new test over the longer term. It wants to gain an insight into the fund’s financial set up and the adequacy of funds from a “continuity perspective”. The funding required will be set in terms of bands. “From the bandwidth, a required amount of capital is generally derived that will cover an institution for financial setbacks without needing to alter its strategic investment policy.
If the continuity test is satisfactory, the solvency test looks to see if there is sufficient capital to cover risks for a year, including market risk of mismatch between investments and liabilities, and deviation from anticipated cost inflation.
The third ‘minimum’ test ensures that the particular time of assessment the level of technical provision for pension liabilities is at least equal to the current value of those liabilities in the market at large; and that the current value of assets covering these provisions are at least equal to the liabilities’ current value. The aim is that if there should be an unforeseen or unintended enforced transfer these liabilities can be fulfilled without discounting the entitlements.
The above tests are for the nominal liabilities, which form the greatest proportion of liabilities. The proposal is to value liabilities using a risk-free interest on European rates, instead of the current fixed 4%, says Rein van Dam of the PVK. “The approach has affinities with the minimum funding requirement used in the UK.”
While pension funds will have to meet all three tests, the PVK is trying to avoid having just one point where the funding is sufficient. “There will be a point where we will say that there is not enough, but we will have a band where a fund can move upwards from red to orange to green and even really green,” he says. The red and orange could be PVK territory, while deciding how far to be in the green could be decided by the social partners.
How to deal with pensions indexation has not been decided and it may also be left to the social partners as to decide as to what levels and the extent to which such guarantees are given. “We see this as a major problem – how to make adequate provision for the indexed part of pensions.” The framework principles will apply to all financial bodies including pension funds, life and non life companies and are expected to be introduced in 2005.