Given the flaws of the HBS, Wilfried Mulder and Niels Kortleve outline a two-step approach as an alternative for a harmonised solvency regime for IORPs

The European Commission is currently working on the modernisation of the IORP-Directive1, following the publication on 27 March 2014 by former Commissioner Barnier of a proposal for a revision of the IORP Directive2. The proposal (IORP II) contains draft text for risk management, governance and information and transparency provisions. It does not include capital requirements. However, when submitting this proposal the Commissioner stated that the Commission would consider introducing capital requirements in the future. 

During the second half of 2014, the Council of Ministers made progress with the IORP-proposal and in December 2014 an agreement was reached in the COREPER, the committee of permanent representatives of the EU member states. The European Parliament (EP) has recently started its discussions on the IORP-proposal.

In the meantime, EIOPA is continuing further work on solvency for IORPs by means of the so-called holistic balance sheet (HBS) approach. This approach, which is supposed to allow for a harmonised assessment of the financial position of EU-based IORPs, was introduced in EIOPA’s reaction3 to a Call for Advice on capital requirements for IORPs by the European Commission in 2011. In the HBS-approach, IORP’s adjustment and steering mechanisms will be included in a ‘holistic’ balance sheet in addition to the ‘normal’ financial assets and liabilities of IORPs. The approach reflects on an essential difference between pension funds (said mechanisms are available) and insurers where said mechanisms are not available.

Following a (first) quantitative impact study (QIS) in 2012, EIOPA started a second consultation on the HBS in the autumn of 2014. As next steps, a further consultation on technical specifications for a second QIS and a second QIS itself are foreseen in the coming months. EIOPA aims at advising the Commission on capital requirements in the beginning of 2016. 

HBS: fundamental shortcomings …
The October 2014 EIOPA consultation on the HBS does not focus solely on the HBS as a tool for capital requirements but also investigates possible use for risk management and/or transparency. This seems a positive step.

However, we foresee that the HBS cannot be developed into a cornerstone of capital requirements. This might be an interesting idea from a theoretical point of view, but is conceptually wrong for several reasons. First, requiring capital for conditional benefits will make these benefits unconditional as extra capital increases their value. This is a clear disincentive to take risk or to offer conditional benefits, especially for funds with a relatively high funding ratio. Second, a Solvency Capital Requirement (SCR) has no place in the HBS, as all benefits and financing methods are already included. Consequently, for a complete contract, the HBS automatically balances, and a SCR would always imply a deficit on a fictitious ‘EIOPA Balance Sheet’ (HBS+SCR). Third, as all recovery mechanisms have to be included in the HBS, any supervisory response cannot improve the HBS; no further recovery is possible.  

… and practical shortcomings 
The HBS-approach also presents various technical and practical problems. There is a serious modelling risk because the outcomes of the valuations are very sensitive to the underlying assumptions. These assumptions may relate to various elements of the HBS, eg, the chosen horizon, the chosen parameters in the (risk neutral) scenario-set and the maximum value of the sponsor support (which may in practice vary between zero and the full value of the technical provisions). IORPs could change assumptions in order to have other, more desirable, outcomes.

And last but not least, the calculation of the options included in the HBS is highly complex and therefore very costly. The numerous simplifications to calculate an HBS offered in the consultation paper in order to mitigate this problem will result in a balance sheet without any logical economic interpretation4. The interaction between the various balance sheet items will be lost and the assumed option prices disregard the price of risk (the expected pay-out on an insurance policy is not equal to its premium).

In view of these shortcomings and inherent flaws, alternative approaches for a future supervisory regime on EU-based IORPs should be investigated as well as a possible role for the HBS, as we will explain further in this article. 

Alternative supervisory approach: goals and conditions 
When developing an alternative supervisory regime for IORPs, defining the main goals of supervision should be the first building block. In our opinion, supervision should focus on the sustainability and affordability of the ambitions of IORPs in terms of pension benefits for participants and their recovery potential (in bad times), that is, on the (current and future) financial position as well as the communication to participants on these issues. Adequate supervision on these issues will, contrary to the HBS-approach, undoubtedly lead to better pensions for participants 

In addition to these goals, specific goals and conditions as expressed by various European stakeholders and organisations should be taken into consideration:

• Improve the protection of participants;
• Improve the EU regulation on DC-systems;
• Avoid supervisory arbitrage;
• Increase, or at least do not diminish, the contribution of IORPs to EU financial stability;
• Facilitate cross border activities of IORPs and accordingly realise economies of scale;
• Avoid impediments to long-term investment;
• Introduce risk-based supervision (eg, by introducing market-consistent valuation, improving risk management and possibly introducing an HBS-approach). We would like to add that this element should in our view not be considered as a goal in itself, but merely as a means of realising several of these other goals (such as protection of participants and financial stability).  

Alternative supervisory approach: main characteristics 
An important precondition for the development of an alternative supervisory framework is the abandonment of the idea of a fully harmonised solvency regime for EU IORPs. 

Moreover, taking into consideration the wide diversity of the national pension systems in the EU member states and the substantial differences between these national systems, imposing detailed harmonised rules is neither necessary nor desirable.

Imposing such rules will probably lead to an increase of costs for IORPs in several member states, which will lead to increased contributions and/or decreased pension benefits.

Furthermore, it makes no sense only to harmonise security levels, because this is just one of the elements of pension schemes besides other aspects such as the accrual rate, the indexation promise and the contribution rate. Therefore, an alternative supervisory framework should in our opinion aim at convergence rather of national regulations rather than on harmonisation. 

Last but not least, harmonisation would also deny the fact that IORPs are not-for-profit social institutions with risk sharing between employers and plan members as an essential proposition. As a consequence, IORPs have no incentive to engage in regulatory arbitrage, which might be the main justification for harmonisation in the view of specific stakeholders.

Based on the aforementioned goals and conditions which might be relevant for European stakeholders, an alternative supervisory framework could consist of the following features. A key element could be the implementation of two layers of supervision: (a) principles and (b) instruments which could be used for supervising the IORP’s ability to realise its goals. 

Principles (first layer)5
• Balanced: A balance should be achieved between a high degree of security and affordable costs to the sponsors and the participants.

• Forward-looking and risk-based: The scope and intensity of supervision should be tailored to the potential risks faced by IORPs and balanced against risk-mitigating factors. The implementation of these principles should be left to the discretion of the member states, taking into account the wide variety of national regulations with regard to these principles.  

• Market-based: In addition to the implementation of this principle the IORP Directive could be extended with a provision that assets should be based on actual market prices.

• Transparent: IORPs should be clear to participants, sponsors and supervisors about their financial position, the target level of retirement benefits and the risks related to these benefits. The IORP should aim at consistency between the capital position (and risks) and the expectations of participants. As such the implementation of this principle will realise a link between the capital requirements and transparency. 

• Proportionate (including cost-efficiency): Supervisory requirements should be proportionate to the nature, complexity and the scale of the inherent risks to participants and sponsors.

• Flexible: The supervisory regime should be able to adapt to changing circumstances (during the financial crisis many member states extended the recovery periods to soften the impact of the crisis on participants, sponsors and economy).

• Countercyclical: Supervisory regulations should include incentives to boost their security (by creating buffers) during favourable economic times and should not impose disproportionate costs on IORPs and sponsors in economically bad times. In respect of this principle the OECD has already come forward with suggestions for potential measures6.  

• Practical: Supervisory regulations should be practical to implement and administer and avoid disproportionate costs.

The detailed implementation of these principles should initially be left to the member states in order to facilitate the diversity in their national approaches and country-specific aspects. The Commission could set harmonised European principles and these principles could be further elaborated where regulatory approaches are similar in member states.  

Instruments (second layer)
Various instruments, which could be part of capital requirements regulations, can be considered:

• Projection-based instruments, such as asset and liability management (ALM, stochastic and/or deterministic), stress tests, continuity analysis and/or sustainability tests;

• Valuation-based instruments7 like minimum capital requirement (MCR), SCR and perhaps the HBS-approach;

• Checklist: In the Netherlands for example, an IORP has to file an ‘ABTN’ (an actuarial and managerial note), which should include elements like investment strategy, actuarial assumptions and risk management. The IORP needs to have a policy on all these elements;

• Dashboard reports: These can be based on the instruments described above, not being available or scoring too low;

In addition to these instruments, there might be other relevant instruments in the national regulations of the member states.

The selection of instruments to be implemented in national regulations should be left to the discretion of the member states, under the condition that they comply with the principles described above. The member states should arrange and apply their supervisory instruments accordingly and could be challenged by EIOPA in the form of peer reviews. Such a peer review will help in developing better instruments over time and improving the supervisory standards across the EU without full harmonisation of capital requirements. At the same time, EIOPA and the local supervisors could improve their understanding of the European diversity of IORPs and supervisory approaches, by collecting broad information about national regulations and practices. EIOPA could make this information public (for example in the form of a mapping or good practices exercise) which would be useful both for other member states and for IORPs. 

As far as the HBS is concerned we see, as stated before, no role for this approach in the context of capital requirements, neither do we see a role for this approach in the context of transparency. This approach is far too complex for participants and does not provide the information that participants need. In our view, the HBS-approach may only be useful for risk management, in order to test the sustainability of the pension agreement. For example, if the HBS had a deficit, even when including its steering instruments, this would illustrate that the current measures available to the IORP are insufficient to cope with all the risks. However, even if used as a risk management tool, the HBS-approach should, in our opinion, never be the only instrument used in this context, but should be combined with other instruments described above.

An additional role for the HBS-approach might be for a better insight into risk sharing amongst stakeholders such as participants of different generations, the sponsor, and in specific cases also government. In the Netherlands, concepts underlying the HBS (ie, a risk-neutral valuation) have been used to check the intergenerational fairness of pension agreements.

Recommendations and conclusion
As explained here, the HBS approach includes many fundamental and practical shortcomings and should as a consequence not become a cornerstone of future EU-regulations on financial supervision on IORPs (or of regulations on information and transparency).

Instead, the features of a potential alternative approach for supervision on EU-based IORPs should be investigated. We advocate that such an approach would not aim at the implementation of a harmonised solvency regime for IORPs. Instead, the current proposal for revising of the IORP Directive – in particular the version of the proposal recently agreed upon by COREPER – should be definitively agreed as the first step. This would, in general, bring supervision of IORPs at a higher level. 

As a second step, we would advocate investigating the possibilities of a further future supervisory approach on capital requirements, as well as risk management and transparency. As described above, the HBS has too many fundamental shortcomings to be useful for capital requirements. We would suggest to set European principles as a form of minimum harmonisation, possibly to be further elaborated where regulatory approaches are similar in member states. 

On top of that, member states should further develop instruments that are adequate given the local setting. These instruments should include projection-based and valuation-based instruments as well as dashboards and checklists, possibly supplemented by local instruments. EIOPA could play a role in developing best practices by challenging the national supervisory approaches and instruments via peer reviews.

EIOPA should be open to developing a vision of the possible combinations of these instruments, spending more time on the development of alternative solutions and less on the HBS, although the HBS could possibly have a role as a tool for risk management. 

Wilfried Mulder is senior policy adviser, group strategy and policy at APG and Niels Kortleve is innovation manager at PGGM

1 Directive 2003/41/EC
2 Brussels, 27.3.2014 COM(2014) 167 final, 2014/0091 (COD)
3 EIOPA (2012), Response to the Call for Advice on the review of Directive 2003/41/EC: Second consultation Frankfurt, 15 February
4 Flaws in the holistic balance sheet, Wilfried Mulder and Peter Vlaar, IPE, January 2015
5 See also AAE, May 2010, Oxford and OECD, July 2010
6 OECD, July 2010, Working Paper on Finance, Insurance and Private Pensions, no.3
7 Projection-based instruments make projections of the (possible) future cash flows and assess these, whereas valuation-based instruments discount future cash flows back to now and assess the value of assets and liabilities.