Philip Shier outlines the issues surrounding the funding standard, and looks at European pension funding trends
The funding standard was established under the Pensions Act 1990 and provides that a scheme’s assets on certification must be sufficient to cover member benefits on termination at that date, as well as wind-up expenses.
On termination, pensions already in payment are secured through annuities, and trustees may pay transfer values to insurance policies, or other pension schemes, to provide for the accrued benefits of other members. The funding standard liabilities are therefore the sum of annuity costs for pensions in payment and standard transfer values (calculated on a prescribed basis) for those not yet retired.
The trustees are required to check annually whether the scheme meets the funding standard: if not, the trustees and employer must agree a recovery plan (called a funding proposal), which is also signed by the actuary, to restore solvency over a three-year period. This funding proposal must be submitted to the Pensions Board within nine months.
Very few schemes did not meet the funding standard prior to 2000. However, more difficult market conditions in 2001-02 meant that many were unable to satisfy the standard at that time, and it was not possible to agree funding proposals to make good the shortfall over a three year period. The requirements were relaxed to give power to the Pensions Board to approve longer recovery periods, usually 10 years, and in most cases the resulting increases in employer contributions were affordable, given the strength of the Irish economy in the ‘Celtic Tiger’ period.
Impact of the financial crisis
The financial crisis in 2008 had a major impact on Irish pension schemes and was exacerbated by significant Irish equity holdings, primarily banks, which lost much of their value. For many schemes, the deficits identified in 2008-09 were of such magnitude that they could not be made good even over an extended timeframe. Initially, the Pensions Board waived the requirement to submit funding proposals in the hope that conditions would stabilise, and this deferral was extended on a number of occasions.
A number of changes were introduced in 2010, including a change to the order of priority on wind-up, whereby future increases to pensions could not be secured until level benefits were provided for all members, and the extension of the power in Section 50 of the Act to apply to the Pensions Board for an order to reduce accrued benefits.
A consultation document on the review of the funding standard was issued by the Pensions Board in 2011. This set out three possible approaches:
• Option A: In which there was no change and there were two alternatives designed to improve the resilience of schemes to future possible crises;
• Option B: A strengthening of the current regime, with funding standard liabilities supplemented by risk reserves to enable the scheme to withstand investment stress of a 15% fall in equities and a 0.5% decrease in interest rate.
• Option C: “A significant revision of the funding standard” based broadly on the requirements of Solvency II, requiring technical provisions using risk-free discount rates and risk reserves to cover simultaneously:
• A fall in equity asset values of 20%
• A change in interest rates (up or down) of 1% per annum
• An increase in expected inflation of 0.5% per annum
The Pensions Board estimated that option B could lead to a 10% increase in funding standard liabilities compared with option A. It estimated that if option C was introduced, the technical provisions plus the required risk reserves (assuming some investment in equity assets) could be at least 50% greater than option A.
The responses to the consultation were generally negative, with concerns primarily about the timing of any strengthening of the requirements, given that many schemes were in significant deficit on the existing basis. Although market returns since mid-2009 had been reasonably strong, the continuing fall in high-quality bond yields increased liabilities, particularly for mature schemes.
2012 changes to funding standard
The Social Welfare and Pensions Act 2012 introduced risk reserve requirements along the lines of option B above, to come into effect by 2016. It also permitted the risk reserve to be met by an unsecured undertaking from the employer or other entity, subject to certain conditions. The maximum term for funding proposals was set at six years, or to 31 December 2023 if longer. Funding proposals with an end date after 1 January 2016 would have to provide for the risk reserve at the end of the period.
The Pensions Board announced that the requirement to submit funding proposals would be reintroduced, with a deadline of 30 June 2013. It is estimated that about 80% of Irish pension schemes do not meet the funding standard, and will be required to submit proposals, although a proportion of these might be wound up. In other cases, future accrual of benefits may be reduced or eliminated, and, where necessary, accrued benefits cut back by means of a Section 50 order.
Another development during 2012 has been the issue by the National Treasury Management Agency of amortising bonds designed to enable insurers to offer sovereign annuities, where annuity payments are conditional on the performance of a reference sovereign bond. This enables the insurer to price the annuities off the yield on the reference bond, and the first issue of amortising bonds by NTMA in August offered yields of about 5.9%, which provided a considerable saving compared with traditional ‘risk-free’ annuities. Trustees are permitted under the Pensions Act to secure pensions on wind up by use of sovereign annuities – subject to detailed disclosure to members – and this reduces the liability for pensions under the funding standard. However, the recent fall in Irish bond yields has eroded much of the anticipated ‘saving’.
Revision of IORP
From the funding standard consultation in 2011, it seems clear that any move by the European Commission to adopt the quantitative provisions of Solvency II would lead to a significant increase in the reserving requirements, well in excess of the risk reserve that has been introduced. At the Commission’s public hearing in March 2012, the Irish government supported the opposition expressed by the German, Dutch and UK government spokespersons to the introduction of a Solvency II-type quantitative requirement.
Ireland is one of the eight countries participating in EIOPA’s quantitative impact study (QIS) for the proposed revision of the Directive. The initial indications are that using the benchmark assumptions specified in the QIS would lead to a significant increase in the technical provisions for active and deferred members compared with the current funding standard, primarily due to the use of the risk-free rate to discount future cash flows. As pensioners are currently valued on an annuity basis under the funding standard, use of the benchmark assumptions should not have a major impact. However, when account is taken of the risk margin (set at 8% for the QIS) and the solvency capital requirements, the shortfalls disclosed by pension schemes under the funding standard would be increased significantly.
The holistic balance sheet envisaged under the proposed Directive allows for sponsor support, pension protection schemes and adjustment mechanisms. As there is no requirement under the Pensions Act, or other Irish legislation, for a company to make good a deficit in a pension scheme on wind up, similar to the debt on employer provisions of UK legislation, sponsor support is not generally “legally enforceable” as required under the QIS and will probably therefore be valued at zero. There is no pension protection scheme in Ireland to meet the shortfall in the event of employer insolvency, so no credit can be taken in the holistic balance sheet for this. A more difficult issue is the treatment of the Section 50 power to reduce benefits on an ex-post basis: taken to an extreme this could be used to balance the holistic balance sheet in many cases, although this result would be nonsensical. Complex issues such as these will need to be considered in further QIS exercises before the impact of the proposals on Irish pension schemes can be reliably assessed.
The QIS exercise does not consider the extent or timing of supervisory intervention under the proposed new regime. It would be impractical for any new regulatory framework to require IORPs to restore solvency over the short periods of time required for insurance companies, and it would seem desirable for national supervisors to have considerable flexibility with regard to issues such as length of recovery plans.
It seems likely that the introduction of more onerous reserving requirements as proposed would lead to the closure of the majority of defined benefit schemes, and the wider implications of this outcome will need to be taken into account in the Commission’s own impact study.
Philip Shier is senior actuary at Aon Hewitt in Dublin and a member of the EIOPA occupational pensions stakeholder group