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Ireland's risk reserve requirement: New duties

Philip Shier and Aidan Kennedy review the new risk reserve requirement for pension funds 

From January, the effective minimum funding requirement for Irish defined benefit (DB) schemes was increased due to the need to hold a risk reserve, in addition to meeting the minimum funding standard (MFS). The impact of this on a scheme will depend on its current funded status, but it is likely to accelerate the de-risking of investment strategies where this can be afforded.

The risk reserve, officially called the funding standard reserve, was introduced in the Social Welfare and Pensions Act 2012 and is calculated as the sum of two elements:

1. A percentage of the excess of the MFS liabilities (and expenses) over the amount of scheme assets which are invested in EU bonds and cash; and

2. The net effect of a fall in bond yields (that is, the net impact of a change in bond yields on the MFS liabilities and the bond assets held) which is intended to address duration mismatching. 

The percentage rate in 1. was initially 15% and the fall in yields in 2. was set at 0.5% but the minister for social protection was given power to amend these and prescribe which assets may be taken into account in the calculation in 1. Initially, assets were restricted to euro-zone government bonds and cash. The minister made regulations in 2013 which amended the percentage in 1. to 10% and extended the qualifying assets to include high quality euro-denominated corporate bonds (defined in terms of yield spread over German Bunds rather than credit rating) and assets in unitised funds (on a look through basis) and insurance policies. For a typical scheme which meets the MFS, the risk reserve might be of the order of 5% of the scheme’s MFS liabilities.

Philip Shier

Philip Shier

The Social Welfare and Pensions Act 2012 empowered the minister to make regulations requiring trustees to comply with statutory guidance issued by the Pensions Authority. The regulations and associated statutory guidance were issued and, among other things, provide that schemes may use unsecured undertakings from the employer to meet the risk-reserve requirements. To date, there is little evidence that such undertakings will be used to meet the risk reserve, not least due to the requirement that the entity must have an ‘A’ or higher credit rating. 

Trustees of schemes – in practice, the scheme actuary on their behalf – have since 2012 been required to submit a funding standard reserve certificate (FSRC) to the Pensions Authority when an actuarial funding certificate (AFC) is submitted (at least once every three years in other words). An FSRC will have been submitted for almost all schemes by now and the annual actuarial data return must show the amount of the risk reserve at the scheme year-end. 

Aidan Kennedy

Aidan Kennedy

The AFC will indicate if the scheme meets the MFS and the FSRC states whether the excess assets over the MFS liabilities and expenses are sufficient to cover the risk reserve. To date, the FSRC has been for information purposes only, but where an FSRC is submitted (along with an AFC) with an effective date on or after 1 January 2016, and the scheme does not have sufficient resources to meet the risk reserve, the trustees will be required to submit a funding proposal – for example, a recovery plan – to rectify the position over a period of not more than six years (or to 31 December 2023, if later). 

Funding proposals submitted to the Pensions Authority since 2011 that have an end date after 1 January 2016 already reflect the requirement to hold a risk reserve at the end date, so there is no action required to address the commencement of the risk-reserve requirements. Earlier funding proposals do not include an allowance for the risk reserve, so when these terminate (when the MFS is covered) action will be required to address the risk-reserve requirement – for example, submit a new funding proposal or provide an unsecured undertaking.

For schemes which meet the MFS and risk reserve, no immediate action will be required, although trustees will need to consider this hurdle when monitoring the funding status of the scheme. The schemes that will be affected in the short term are those where the MFS is satisfied but where there are insufficient assets to meet the risk reserve. However, as the detail of the risk reserve has been known for some time, there should already be a plan to address this. A secondary consequence is that the statutory power given to trustees to refuse their consent to early retirements has from 1 January 2016 applied where the scheme does not meet the risk reserve; until now that trustee power only applied where the scheme did not meet the MFS.

It is difficult to argue against the requirement that schemes can ride out some level of future volatility. Clearly, the level of the reserve can be minimised by holding a high proportion of the scheme’s assets in (qualifying) bonds and cash, and this is consistent with the de-risking objective of many trustees. However, progress towards this objective has been slow, primarily due to the low yields on bonds, which have made switching unaffordable.

The 2014 OECD review of the Irish pensions system noted that the revision to the funding standard to incorporate a risk-based element was consistent with approaches in other states, but that it was unusual in vesting the power to set and vary the level of the reserve with government rather than to the regulator. It also noted that, even with the additional requirements, the Irish funding standard remains undemanding in comparison with other OECD countries. 

There are, however, some aspects of the risk reserve as it currently stands which cause concern, including:

• Exclusion of asset classes that can assist with liability-risk management, such as non-euro-zone bonds and swaps or derivatives used to hedge interest rate risk; and
• The level of the interest rate shock inherent in the second element of the risk-reserve calculation, currently at 0.5%, in the current low-yield environment.

A related question that remains to be clarified, as schemes increase their allocation to absolute return asset classes, is the extent to which the cash holdings of such products are deemed qualifying assets, given such holdings are generally earmarked as collateral for underlying derivative based strategies. A consistent approach by both investment managers and scheme actuaries would be desirable.

There is ongoing engagement between the Society of Actuaries in Ireland, the Irish Association of Pension Funds and the Pensions Authority in relation to the risk reserve and draft regulations expanding the definition of admissible bonds to include non-euro bonds hedged back to euro have been circulated to interested bodies. 

However, these revisions have not been implemented and it remains to be seen to what extent there is an appetite for further change in the short term. 

Philip Shier and Aidan Kennedy are senior actuaries at Aon Hewitt in Dublin. Shier serves as chair of the EIOPA Occupational Pensions Stakeholder Group and the Actuarial Association of Europe. Kennedy chairs the Pensions Committee of the Society of Actuaries in Ireland

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