Squeezed from all sides
Rachel Fixsen reviews the regulatory pressures facing European pension funds
Across Europe, pensions regulation has tightened over the last few years. Legislators have weighed in with various supervisory systems aimed at safeguarding occupational pensions benefits for current and future pensioners.
No one can doubt that a lot is at stake, and only hard-bitten cynics question the motives of the authorities calling the shots. But pension funds have nevertheless had to work harder than ever to meet the challenges presented by regulators.
“In the UK, pensions legislation is being issued at an unprecedented pace with three pensions bills and over 300 statutory instruments since 2004,” says Jane Beverley, head of research at Punter Southall. “The Pensions Bill currently going through parliament will provide a range of extended regulatory powers for the Pensions Regulator to intervene in the running of occupational pension schemes.”
In the Netherlands the introduction of the financial assessment framework (FTK), which was implemented at the beginning of last year, has also increased regulatory pressures. But it is arguable that the step change has not been as significant as in the UK.
The FTK was part of the new Pension Act, which also included pension fund governance principles and more emphasis on information and communication.
“It really was a tough job to get everything done, but pension funds managed to comply with the new rules and regulations,” says Leny van der Heiden-Aantjes, acting director of the Association of Industry-wide Pension Funds (VB).
Under the FTK rules, Dutch pension funds must keep their solvency levels within the limits set down from year to year if they are to avoid onerous demands from the Dutch pensions regulator, De Nederlandsche Bank (DNB). In April, DNB reported that as a result of recent market turmoil, some of the country’s pension funds had seen their coverage ratios drop below the limit of 105%, with 10% of schemes having a ratio of less than 125%.
“The pension sector is somewhat worried by the instability of the financial market,” says Van der Heiden-Aantjes. “We struggle with the balance between insight into our financial position on a daily basis and our policy and objectives for the long term. This balance is delicate.”
Colin Busby, communications manager at Universities Superannuation Scheme (USS) in the UK, agrees that there is a considerably greater regulatory load compared to several years ago.
He cites the age discrimination legislation, the Pension Protection Fund, the trustee knowledge and understanding component of the Pensions Regulator’s codes of practice, cross border schemes, A-Day - a new set of pension rules that came into force two years ago, aiming to simplify pension saving for individuals - and S75 employer debt (changes in the way debt is calculated from an insolvent employer to pension scheme trustees).
“Bigger schemes have had to find time and resources to cope, but some smaller schemes are not coping and may ultimately decide to close as a result,” says Busby. “There is a greater administrative burden and some schemes may have taken on more staff or outsourced. There is definitely a need for more professional advice on these issues, which increases fees.”
Samuel Sender, research associate with the Edhec Risk and Asset Management Research Centre in Nice, also finds that the changes have reinforced the tendency for market outsourcing, as well as a shift in benefit structures. “With the additional accounting constraints, there has been a large shift away from traditional defined benefit plans to either hybrid forms or even pure defined contribution plans,” he notes.
The UK, he says, has the most flexible pensions regulation in Europe, allowing for underfunding. However, it is also the country with the most severely underfunded pensions industry. In contrast to the UK, Sender notes that in the Netherlands, defined benefit pension plans have not been closed. “But the industry has established fair rules for the risks of low returns to be shared between employees and employers,” he points out.
More and more companies in the UK have been looking at ways to manage their pension risks more effectively, Beverley finds. “From the perspective of the pension fund itself, the primary burden of regulation has been in the amount of time that trustees and pensions managers have had to spend in understanding the latest developments in regulation, and the implications for their pension schemes.
“There have also been cost implications - trustees need to take actuarial and legal advice much more frequently in order to be sure that they comply with new regulatory demands. “Inevitably the regulatory burden has led to employers closing existing defined benefit schemes, and looking at new less regulated types of arrangements, such as self-invested personal pensions”.
“The biggest concern that pension funds and the industry in general has is what seems like a regulatory ratchet from a variety of sources,” says David McCourt, (pictured left) a policy adviser on investment and governance issues at the National Association of Pension Funds.
“This has particularly been the case in the defined benefit sector and it is important that some overall stability is maintained and the compliance burden reduced as soon as possible. Consequently, the NAPF welcomes the deregulatory measures that the UK Government is putting in place.”
How pension funds have coped, at least in the UK, varies from case to case, according to McCourt. “Each pension fund is different with scheme specific issues so there has been a variety of responses but I would suggest nearly all employers and trustees will be reviewing their pension strategy on a more regular basis going forward.
“The rate of UK pension schemes switching from offering new employees defined benefit pensions to defined contribution schemes has largely subsided,” he observes, citing the NAPF’s 2007 survey, which showed 31% of DB schemes surveyed remained open compared with 33% the year before.
“However, there has been an upward trend in risk management, diversifying asset allocation and a move to the use of LDI strategies,” he says. “In addition, some DC schemes have been moving from trust-based to group personal pension and stakeholder pensions [a type of individual pension scheme] and of course, there is the growth of the buy-out market.”
McCourt says the key issue for pension schemes has been an increase in the costs of running schemes. “Whilst running costs are just under 0.4% of assets under management, since 2005 there has been an increase in fund management, levies and adviser costs of 105%, 530% and 62% respectively.
“In addition, there has been a trend towards appointing more independent professional trustees to assist with the governance of schemes.”
Certainly it is true that for pension funds in Sweden and Norway, there has been more supervision and regulation in the last few years, according to Jan Bernhard Waage, managing director of Wassum Investment Consulting in Stockholm.
“The EU pensions Directive in that period has had a very substantial impact on the way pension funds are regulated and what they’re allowed to do. “The Directive has led to the market valuation of liabilities which has in turn had a severe impact on activities,”
“Pension funds are including liabilities in their strategies much more, matching assets to liabilities to a larger extent than before, but it’s not been a huge trend,” he says. “It’s been a gradual change, and some have decided to stay quite short on the bond side and gradually increase that as interest rates rise.
“Pension funds are more interested than they were in alternative investments and hedge funds. They are more interested in high alpha, and active managers; they need to have better diversification even in a matching portfolio, and there is a demand for emerging markets investments and in particular hedge funds.”
When lawmakers do introduce new rules for pension funds, the economic timing is vital, argues Chris Verhaegen, (pictured right )secretary general of the European Federation of Retirement Provision.
“The moment of the economic cycle at which you introduce onerous regulation is crucial for policy not to be needlessly disruptive,” she says. “The UK experience is a case in point. When FRS17 was introduced, it was at a bad point in the economic cycle, and it has had a devastating effect on DB schemes; it should have been introduced during an upswing.”
Peter Preisler, director of business development at T. Rowe Price, acknowledges the side effects of greater regulation, but is clear about the necessity for it. “No one makes up new regulations because there’s nothing else to do. It’s caused by something. Bad experiences call for regulation,” he says.
Preisler likens the need for pensions regulation to the need for speed limits on roads. Speed limits are necessary because it has been proven over time that when people drive too fast, more accidents happen. But on the other hand, the limits imposed are often too strict to allow an optimal use of the road system, he says.
“I would say some of the regulation has that characteristic too… but it’s put in place to protect pensioners. Over time the regulation will not go away, and it will put pressure on pension funds to do things efficiently.
Many have argued that frequent solvency checks on pension funds force them to invest with a view to the short-term - wiping out the advantage they have in being natural long-term investors. “Short-sighted investing may be reassuring for the management of pension funds because it may allow them to be fully aligned with regulatory requirements,” says Sender.
“However, it is dangerous not only because it means losing the benefits of long-term investing, but also because it means failing to replicate long-term real liabilities and damaging the position of the pension fund over the long run.” The money market is riskless in the short run but risky over the long run because future interest rates are unknown, he says.
“For a pension fund, the essential riskless portfolio is the one that fully replicates the liability over the long run. In the example of real liabilities - when pensions are indexed to inflation or wages - some real assets such as equities and property are needed for long-term replication.
“In the case of last-wage pension plans, the riskless ALM security for very long term liabilities are equities, because just as wages they are driven by economic growth over very long horizons,” he continues. “However, equities are the riskiest security over the short-run, which means that the long term equilibrium of pension plans can often only be achieved at the expense of short term volatility.”
One piece of looming European legislation that has caused an outcry from European pension funds is the Solvency II directive. Though aimed at insurance companies, the draft law contains requirements considered far too stringent for pension funds to work with.
However, it now seems that pension funds will not be subject to the problematic rules after all, Verhaegen points out. “The directive is at the Council, and we are happy that Peter Skinner - MEP and Parliamentary Rapporteur on the Solvency II directive - has tabled an amendment to the Solvency II directive, to make it crystal clear that the pension funds and IORPs can continue to work under the Solvency I rules,” she says.
“We hope Mr Skinner will be successful, Although some French and German MEPs have already voiced some criticism.” The legislation is likely to be passed later this year or early 2009, she says.
UK fund USS is cautiously optimistic about the latest developments. “We are pleased at the recent announcements which suggest there is no intention of extending Solvency II to IORPS, but - together with the NAPF - we remain watchful of developments in this area,” says Colin Busby.
But Jane Beverley sees a risk that the review of the IORP Directive could introduce something like the Solvency II directive by the back door. “CEIOPS recently published an initial review of the implementation of the IORP Directive, which found that, whilst there was considerable diversity in the way that it had been implemented, this had not produced any major problems,” she says. “We hope that the EC will share CEIOPS’ pragmatic view.”
And even though some commentators suggest Solvency II might be off the agenda for pension funds, John Broome Saunders, actuarial director of BDO Stoy Hayward Investment Management, suspects some tightening of funding standards is likely in the UK at least.
“Especially if it allows some levelling of the playing field for FSA-regulated and occupational sector players,” he says. “It is worth noting that the Regulator has not yet had to impose a funding rate in a case where trustees and sponsors simply cannot agree on funding. The imposition of such a rate will be a seminal moment - and is likely to set a more objective, and probably higher, funding standard by the backdoor.”
In the UK, there are now proposals on the table from the Pensions Regulator on longevity and the Accounting Standards Board on how plan sponsors and pension funds report their pension costs especially liabilities, McCourt reports. “Whether changes need to be made depends on the eventual outcome of their proposals,” he says.
“Looking further ahead, one of the biggest issues is the introduction of Personal Accounts and auto-enrolment in 2012 and the impact they could have on UK pension provision in general. The deregulatory issues currently going through Parliament will be a welcome first step, but the process must not stop there,” he stresses. “Deregulation must be a continual process.”
But Beverley is doubtful about how much real progress is being made towards untangling the supervisory web. “While there has been much talk about deregulation, so far we have yet to see any meaningful steps in this direction,” she says.
In the Netherlands, the VB does not expect any new rules and regulations for pension funds, despite the recent falls in asset levels. “The cover ratios are somewhat lower, but pension funds have buffers to cope with the lower cover ratios. And the new assessment framework (FTK) already has requirements for pension funds on what to do in case of an insufficient cover ratio,” says Van der Heiden-Aantjes.
In Sweden however, says Waage, the regulatory process does have further to go. “What we see is the regulations around the other pension funds also being changed,” he says. “Corporate pension funds have not been that affected by regulations so far. The ability to take money in and out of the pension funds is going to be regulated, and these market valuations. We see more of this kind of regulation over the next two or three years; there are still pockets in the market where they are using fixed interest rates to value liabilities.”
Preisler favours the more ‘dynamic’ solvency regulation, such as the traffic-light system in Denmark and Sweden and the FTK in the Netherlands, which allow greater investment freedom for those funds that have proved high solvency levels. “I think this approach will spread,” he says.
Pan-European pensions regulation?
While harmonisation is arguably at the heart of EU lawmaking, attempts to force Europe’s diverse occupational pensions to comply with the same set of regulatory demands would be problematic, according to the European Federation of Retirement Provision (EFRP).
“The CEIOPS is going for more harmonisation in supervision and would like to see also more harmonised regulation,” says Chris Verhaegen, secretary general of the EFRP. “In our view, this is worrying because of the diversity in workplace pension provision.”
“The fact that there is a high level of diversification within national pension provision is something very difficult to cope with at a European level,” she says.
“Legislators nowadays want workplace pensions to be a hard promise and not flexible. This is in fact modifying the idea at the heart of work place pensions. It goes against the idea there is a group of people - sponsoring employer, active and deferred members, pensioners - that have agreed funding together a pension promise which would be delivered as is best possible given the economic environment throughout their life cycle.
“This change has never been made explicit but is undoubtedly present in the mind of regulators and politicians now that private pension provision increasingly is becoming a necessity whereas in earlier days - especially in continental Europe - it was considered as a top up for statutory pensions which were expected to be generous.
“The reality of today is that statutory pensions are becoming quite basic incomes requiring additional retirement income,” she says. Apart from this, there are huge variances across Europe in the level of those statutory pensions expressed in euros. “Therefore, I don’t think there can be a Europe-wide pensions policy in the near future.
“When you compare how pensions schemes are in France and Germany, they are very different. This harmonisation logic cannot be put into occupational pension schemes either then.”