Looking over the regulatory fence

When the scale of the pensions crisis hit home, legislators across Europe felt forced to act. It was not only the stock market collapse at the beginning of the decade, but also the looming spectre of an ageing population that prompted a wave of new regulation across Europe.

Rules on safeguarding value for scheme beneficiaries may have been tightened up, but many in the industry bemoan the increased workloads and restricted investment freedom.

Will pension funds stand for it? In theory, at least, they do not have to. Under EU law, pension funds are now free to base themselves in another member state with a more favourable regulatory regime. So, if the regulatory burden proves too great, just how many of Europe's pension schemes will go jurisdiction shopping?

It is still very early days, according to Chris Verhaegen, secretary general of the European Federation of Retirement Provision. "Now there are some regulations in place, and the Belgians have been very active in promoting this," she comments. "It now remains to be seen whether there is interest in the market."

The EU pensions directive paved the way in 2003 for pan-European pension schemes, or IORPs, and it has since been implemented by the member states. It is now possible for a fund to relocate to a different member state and run its operations from there.

Verhaegen says a lot of pension funds are looking into the possibility of relocating, and are busy doing their homework, which includes asking consultants and lawyers about the implications such a move would have. But, she insists, undertaking such an operation will not be easy.

When the pensions directive was in the process of being implemented in the UK, the consultation paper envisaged two main scenarios in which pension schemes might use their new chance for mobility, says John Wilson, head of research at HSBC Actuaries and Consultants.

"The first was the multi-national model, and the second was where a provider wants to site a scheme in another member state for commercial reasons," he says.

It is the larger pension schemes that might, in the future, take advantage of the ability to switch domicile for the sake of a lighter regulatory touch, rather than the smaller or medium-sized ones, Wilson suggests.

But so far, few pension schemes seem to have taken advantage of their new-found freedom. According to the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), there are now 48 cases of cross-border pension provision, but only nine of those started operating on a cross-border basis after the 23 September 2005, when the IORPS directive was transposed into national law.

Most were pre-existing cases where an employer had employees in more than one member state. However, in its report CEIOPS said it anticipated many more cases in the future.

Paul Kelly, senior consultant in global consulting at Towers Perrin, recently attended a presentation given by the Belgian prime minister aimed at encouraging European pension funds to base themselves in the country. The new regulatory regime, Kelly remarks, is more qualitative compared to some structures elsewhere in Europe - such at the FTK framework in the Netherlands - which tend to be quantitative.

It is hard to say how easy it would be for a UK scheme, for example, to shift location to Belgium in practice, Kelly says. But continental pension funds seem to be more willing to contemplate such a change.

"In the UK, our clients are saying: ‘Why should I think about going cross-border?' Whereas in continental Europe, clients are saying: ‘Why shouldn't I?' There is growing interest from continental Europe, particularly in Benelux," he says.

In Scandinavia, there are now strict rules governing permitted fluctuations in asset values under the traffic-light system. The rules are in place for Sweden and Denmark, and a similar version is likely to be introduced in Norway. However, Nicklas Fahlström, senior consultant at Wassum Investment Consulting in Stockholm, certainly does not see Swedish pension funds rushing to find a domicile with more relaxed regulation. "I'm not expecting a big migration for Swedish pension funds, even if it were possible to do so," he says.

"They would have to have really good reasons for doing so," he continues. In any case, he doubts that the current level of regulation is seen as negative by Swedish pension funds.

"The traffic light system is in essence a good thing; it ties the assets and liabilities together for pension funds for the first time - which is the real world, of course," he points out. "These are not portfolios with absolute risk."

In the Netherlands, the new FTK rules aim to boost confidence in the Dutch retirement system by safeguarding the solvency of the schemes.

But in the run up to the new legislation, many in the industry criticised the rules, saying they would put too big a burden on the sector. And privately, pension funds are critical of the regime.

Although shifting operations to another jurisdiction is a theoretical option for a Dutch pension fund, Roland van Gaalen, consultant at Watson Wyatt in the Netherlands, feels that in practice this is unlikely to happen.

"Dutch pension funds tend to be somewhat independent as legal entities, under joint governance with employee and employer representatives on the board of trustees," he says. "From that perspective, would a pension fund want to move to another country with less strict regulations? Probably not, because the members are concerned about their own benefits," he adds.

In the process of complying with all the regulations, Dutch pension funds are undeniably facing too much paperwork now, Van Gaalen insists, and it is high time some kind of paperwork reduction act was brought in.

"The rules are becoming rather complex on asset allocation, contribution policy and governance," he says. Small- and medium-sized pensions funds in particular are the ones that suffer under the weight of the extra administration required rather than the larger funds, he adds.

Watson Wyatt does take the governance issue seriously, Van Gaalen says. "There is definitely a risk that the governance issue is getting out of hand," he notes, pointing out that pension funds now have to have data verified by independent auditors, independent actuaries as well as supervisory authorities.

"I don't think we need any extra layers of oversight as far as governance is concerned, and a little more streamlining would definitely be in order," he says.

But while much of the new regulation is tough for Dutch funds, Van Gaalen says it can be argued that the FTK solvency rules are not strict enough.

"The consensus here in the Netherlands is that we want indexed pensions, but the minimum funding requirement focuses on nominal pensions only," he says. "We know that typically the liabilities for indexed pensions are around 50% higher than that for nominal pensions, so if the FTK requires a minimum funding ratio of 130% - including a solvency margin - is that really excessive, in view of the fact that if you want an indexed pension you need around 150%?"

Most pension funds do take this into account anyway, regardless of the regulatory requirements, he explains, and typically set their contribution level at a level where they will be able to provide indexed pensions. "So that means that in reality, they are funding more than the minimum," he points out.

"FTK emphasises the protection of nominal pensions, and doesn't pay enough attention to the liabilities for indexation," he adds. Within Europe, the burden of regulation varies by country, Kelly goes on to say.

"The UK is getting to grips with funding and there have been a whole series of debates with sponsors, some of which have been very robust indeed," he says.

All parties involved have an interest in making sure the discussions are as constructive and fruitful as possible, Kelly continues. "But you need a framework for that to happen; there's been no industry standard so sometimes it has been adversarial," he says. The two main regulatory issues pension funds in the UK have been grappling with are scheme-specific funding and the debt issue of Section 75, according to Kelly. The pensions regulator has been very active in giving guidance on how scheme-specific funding issues should be resolved.

"Typically, in return for its support the company requires the trustees to agree to certain things from their perspective, for example, investment strategy assurances," says Kelly.

The Section 75 debt issue is a regulatory burden which affects multi-employer pension schemes when an employer leaves the scheme, he adds. In today's climate of increased M&A activity, it is common for subsidiaries to be sold, leaving a multi-employer scheme with a Section 75 debt.

Wilson says he and his colleagues have never been any busier in terms of the compliance aspect of their work. "There is still a lot of activity as fall-out from A-day, when the single tax regime came in in April 2006."

The issue of governance and internal control is also prompting a lot of queries from clients, he adds. On top of this, employers managing defined benefit (DB) liabilities are seeking advice on how to make sure they are complying with the plethora of regulations. "They have to make sure they're not doing anything that will raise an eyebrow with the regulator," Wilson says.

Many DB pension schemes in the UK are required to pay a levy to the Pension Protection Fund. "We've been very busy working in exercises with schemes to try to keep that levy to a minimum," says Wilson. The levy for 2007/08 is expected to go up quite substantially, he adds.

Compliance-related work may be at a high for UK pension schemes at the moment, but Wilson sees light at the end of the tunnel. "We do have a de-regulatory review coming," he says.

The proposed new EU insurance solvency rules - Solvency II - are casting a shadow over the pensions industry. In their current form, many believe they would damage pension funds, forcing them to move out of equities.

In its current shape, Solvency II has a requirement for companies holding equities to have enough regulatory capital to withstand a 40% stock market fall in one day. But the precise form the regulations will eventually take, and whether they will apply to pension funds, is still unknown.

Thomas Steffen, the current chair of the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), says the preparatory work of European supervisors on Solvency II has now been completed successfully, and CEIOPS has delivered around 1,000 pages of advice to the European Commission on the issue.

"The Commission has announced it will present its proposal for the framework directive on 10 July 2007," he says. "The new regime will not yet apply to pension funds. If the Commission asks CEIOPS to give advice on Solvency II and pension funds we will certainly do so." In the meantime, there will be political negotiations on Solvency II in the European Council and Parliament, Steffen explains, with a realistic expectation that it will be finalised by early 2009 before the election of the European Parliament.

"Assuming a transitional period of two to three years, Solvency II could start around 2011-12," he suggests.

The EFRP has a working group collating data in order to present legislators with a response to the proposals, according to Chris Verhaegen. "We are still gathering information from our members, and our target is to have something published at the end of this year," she says.

Van Gaalen believes Solvency II is unlikely eventually to affect pension funds when it finally becomes a legal requirement in Europe.

"Pension funds are fundamentally different from insurance companies, and Solvency II is designed primarily for the insurance industry," he says.

Solvency II requires a 99.5 % confidence level, whereas Van Gaalen believes the 97.5% confidence level that the FTK rules demand is more appropriate. "If you insist on having a very high confidence level, then you're basically forcing pension funds to avoid all investment risk and I don't think that's a very good idea," he explains.

"It would be hard strategically for pension funds, and I think the politicians will realise that," he adds.

UK PPF levies and scheme-specific funding

The 2004 Pensions Act in the UK made some big changes to pension fund regulation and supervision, notably the creation of the Pension Protection Fund (PPF), and putting a scheme-specific funding requirement in place of the minimum funding requirement (MFR).

Under the new regime, pension schemes have various new obligations, including the drawing up of a Statement of Funding Principles (SFP), which has to set out the scheme's strategy for funding its pension commitments and for correcting deficits.

Many pension funds now have to pay annual levies to the PPF, which is designed to compensate scheme members if the sponsor becomes insolvent. The amount a scheme has to pay depends on a number of factors, including the volume of contingent assets it has in place. Schemes have to have regular actuarial valuations based on a funding approach consistent with the strategy set out in the SFP. Communication with scheme members must be effective to make sure they are better informed about the funding of their scheme.

While the old MFR required funded defined benefit pension schemes to hold a minimum level of assets to meet liabilities and set out time limits within which any underfunding had to be topped up, the new scheme-specific funding requirement is more qualitative.

On a practical level for pension funds, it means trustees working with sponsors to satisfy the pensions regulator about the quality of long-term funding.

Netherlands and FTK

At the beginning of 2007, the Financial Assessment Framework or Financieel Toetsingskader (FTK) rules came into effect for pension funds in the Netherlands.

Under the new rules, pension fund assets have to be above a certain level in relation to liabilities. If a pension fund's assets fall below the minimum coverage ratio of 105% of its unconditional liabilities, it then has three years to correct this. These unconditional liabilities normally exclude any and all future indexation.

The fund is then also subjected to a solvency test. The required solvency cushion is intended to protect against the risk of the coverage ratio falling below 100% within a year.

On top of this, a stochastic analysis on a continuation basis with a 15-year horizon - the so-called continuity analysis - must be performed every three years to examine the consistency of the whole pension deal and the way it is financed, including the aspect of non-guaranteed indexation.

One of the big changes is the introduction of fair current value as a valuation basis for both liabilities and investments. As well as this, under the new regime, institutions have to provide supervisors with an explicit analysis of the way they safeguard continuity through the design of their financial structure.

Scandinavia and the
traffic-light system

Supervisory authorities in Denmark and Sweden have sought to bolster pension fund security in recent years by introducing a traffic-light model.

In Sweden, the traffic-light model measures companies' exposure to various risks and calculates a capital buffer based on the fair value of both assets and liabilities. Then the company undergoes various theoretical stress tests, laid down by the Swedish financial supervisor Finansinspektionen.

These stipulate scenarios under which asset prices fall steeply - or in the case of fixed income, scenarios under which asset prices rise sharply or fall steeply. There are different levels of price changes for each asset class.

The net effect of each asset price change is added up according to a square-root formula, and if the company's capital buffer becomes negative as a result of the scenarios, then this means a red light. This is the supervisor's cue to conduct, as it puts it, "more in-depth measures that are both quantitative and qualitative in nature".

The system in Denmark works in a similar way. Norway's pensions supervisory authority Kredittilsynet proposed introducing the same
kind of traffic-light system in late 2005, and discussions within the industry are still continuing.