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Top 1000 Pension Funds: Improvement, not punishment?

Michel Barnier appeared to make a major concession when he announced a delay in the implementation of solvency requirements in the revised IORP Directive last May. But the result has arguably not been greater clarity. Cécile Sourbès outlines a number of scenarios for the future of the Directive

The European pension industry breathed a sigh of relief when Michel Barnier, the EU commissioner for internal market and services, announced on 23 May 2013 that the implementation of capital requirements in the revised IORP Directive would be postponed.

After the industry’s effort to fight the proposals, even the slightest move from Brussels came as a small victory for pension fund representatives. So when Barnier argued that the solvency rules for IORPs should be an “improvement for the pensions sector, rather than a punishment” after seeing the preliminary results of the first quantitative impact study (QIS) for the directive, the first reactions coming from the industry were punctuated with delight.

But the relief did not last long. And after more consideration, it became clear that, even though Barnier himself would not go ahead with pillar one, the new commissioner appointed in 2014 could still do so, meaning capital requirements might sooner or later be back on the table.

Beyond that also came the transparency and governance issues set under pillars two and three respectively of the revised directive. In his speech in May, Barnier stressed that a legislative proposal would be published some time in the autumn of 2013. But it remains uncertain what the proposal will contain.

It is then fair to say that the final version of the revised IORP Directive has never appeared so unclear to the pension industry. But there are a number of scenarios for the potential final outcome.

Pillar one: capital requirements
Some pension representatives still secretly hoped until this summer that the move made by Barnier on pillar one would see Brussels definitively drop capital requirements for IORPs.

But the wake-up call came at the QIS closing event in Brussels on 10 July when the chair of the European Insurance and Occupational Pensions Authority (EIOPA), Gabriel
Bernardino, announced that EIOPA would seek to improve definitions and methodologies for assessing the holistic balance sheet (HBS) after it conducted a first quantitative impact assessment (QIS) on the matter. More importantly, he said he would present further tested technical proposals for a European risk-based prudential regime to the next commission.

The HBS is an extension of the traditional balance sheet, stating unconditional assets and liabilities next to conventional ones, and, unlike Solvency II, considering external elements to the institution concerned. The idea of the HBS approach has always been clear – it should ‘capture’ the wide variety of occupational pension models across the EU, as Bernardino reminded in his speech. When introduced in the early consultation papers for the revised IORP Directive, the HBS was presented as a means to create a harmonised pension system. It also sought to deal with diverse security mechanisms employed by IORPs across Europe and act as a supervisory tool.

However, the outcome of the first QIS revealed some disparity between IORPs taking part in the exercise. Not only did it reveal high deficits in a number of EU member states depending on the scenario adopted – either the benchmark, the lower-bound or the upper-bound scenario – but it also highlighted the difficulty to harmonise pension systems in the EU.

Needless to say, if EIOPA decides to push further for the introduction of some kind of HBS approach within the revised IORP Directive, as Bernardino’s speech seems to suggest, it will have no other option but to conduct future work on the matter, through new rounds of QIS. This is precisely what the authority requested in both the preliminary and the final report on the first QIS it sent to the Commission before summer.

Such work could take several years at least. By the time Barnier’s replacement is appointed next summer, and by the time EIOPA is done with conducting one or more QIS to fully assess the impact of the HBS, pillar one of the revised directive might not come to light before 2015 or 2016 in the best case scenario.  

Meanwhile, the Commission might then want to adopt another strategy. One option would be to introduce similar capital requirement rules indirectly, through the Own Risk Solvency Assessment (ORSA) tool. ORSA, which is currently being drafted, will be introduced as part of the Solvency II framework for insurers.

Under Solvency II, insurance companies will be required to perform their own risk and solvency assessment, which will then become a component of their risk management system. Beyond insurers, pension funds might also have to enter into a “lighter” ORSA process in future, as EIOPA has already suggested.

But, even though EIOPA has said that only a ‘diluted’ version of ORSA might apply to pension funds, now pillar one of the revised IORP Directive has been dropped – at least temporarily – the authority and Brussels could adopt a much stricter approach. This could then lead them to strengthen the ORSA for occupational pensions and introduce some solvency capital rules.

Although the present consensus is that Solvency II is unlikely to come into force before 2016, ORSA for insurers could potentially come as soon as 2014, so could the one for pension funds.

Pillar two: governance
Unlike the first pillar, where the pension industry does not have any visibility on the timetable, Barnier made clear that a legislative proposal would be launched in the autumn on governance and transparency issues – second and third pillars respectively.

Pillar two covers internal control rules, which would oblige occupational pension schemes to have sound administrative and accounting procedures and adequate internal control mechanisms – including a compliance team. These measures are already set in the first IORP Directive.

Pillar two of Solvency II requires institutions to conduct their own internal audit and this requirement is most likely to apply to IORPs in the revised directive. This point appears more problematic in the sense that the existing directive does not refer to that particular function. If introduced, the internal audit measures would then be based on article 47 of the Solvency II framework for insurers. That article states that insurers “shall include an evaluation of the adequacy and effectiveness of the internal control system and other elements of the system of governance”.

Moreover, on the internal audit side, pension funds could be presented with several options to comply with the requirements. They could either appoint an internal auditor who would not be involved in the management of the scheme or outsource the function to a third party.

But who would be required to comply with those rules? Under the revised directive, the Commission has set a concept of ‘proportionality’ to avoid placing a regulatory burden on an IORP that is disproportionate to the scheme’s aims in the way of member protection.

At this stage it is unclear whether Brussels will assess the ‘proportionality’ criteria according to the size of the pension fund or the risk taken.

A proportionality approach relative to the size would mean that Brussels would only require large IORPs to apply the internal control and internal audit measures. Under the internal control system, it seems EIOPA would only expect larger and more complex IORPs to have an internal or even external control team to advise the board on compliance issues.
This team would, of course, be separate from the governing board.

As a result, the real issue with pillar two is that IORPs might have need of greater professional support or additional trustees or committee members to help with compliance issues, all of which have a cost. In a previous interview with IPE, the French pension fund UMR’s former CEO, Charles Vaquier, said his fund might have to recruit two additional staff members to focus solely on governance issues. And the requirements set under pillar two could be even more of an issue for larger pension plans as they will certainly not benefit from the ‘proportionality’ rules.


Pillar three: transparency
Further costs might stem from the third pillar of the revised directive, under which occupational pension funds would be required to disclose certain data to both regulators and members.

In October 2012, the European Central Bank (ECB) stated in its response to a consultation paper on the launch of the QIS that future reporting requirements for pension funds could contribute “significantly” to the information required by the European System of Central Banks (ESCB). The ESCB said detailed information on the assets held and liabilities issued by IORPs was essential, not only in terms of outstanding amounts at the end of a period, but also in terms of transactions that occur between two reporting periods.

“Quarterly security-by-security reporting for the securities portfolio of IORPs is important in underpinning macroeconomic and macro-prudential analyses,” the ECB wrote.

“This will enable to monitor and better interpret changes of the securities portfolio and the inter-linkages with other financial intermediaries, and will also contribute to the assessment of risks.”

Although it remains difficult at this stage to predict what final proposals on pillar three the Commission will put together, such requirements will probably be part of the data occupational pensions will be asked to disclose to regulators.

To that extent, pension experts in the EU argue that greater reporting on a wide range of data would lead to increasing costs.

As for the requirements on disclosure to members, Brussels and EIOPA may copy and paste some elements set under the Key Investor Information Document (KIID), originally designed for the UCITS IV Directive.

KIID is a two-sided information sheet that gives investors all the key facts and figures about the fund they invest in. The Commission requires all fund managers to have a standard layout with sections describing what the fund does, the investment risk, the fees they charge and their performance. Brussels aims to standardise the presentation of information in the view of making it easier to compare funds from different providers.

Under pillar three, Brussels could require all EU pension funds to provide a similar document to inform their members on the investment strategy adopted by the IORP, the investment risk and the return on investments. Also, Brussels will probably require pension schemes to disclose the level of pension income European workers may claim at retirement.

It remains to be seen what final requirements on capital, transparency and governance issues the Commission will pull out of its hat in the coming months.

But until the Commission makes a formal announcement on pillars two and three in the autumn, and on pillar one later this decade, the pension industry will have to remain on its guard.


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