This year the directive on institutions for occupational retirement provision (IORP) must be implemented in all EU countries. How will it affect financial markets? The directive may affect asset allocation procedures and outcomes. It requires a cover ratio of 100% at all times (art 15 and 16), it sets quantitative restrictions on asset allocation that do not bite (art 18), it prohibits discrimination by nationality on the choice of managers and custodians (art 9) and it opens possibilities for cross-border activities (art 20).
The IORP directive covers occupational retirement schemes, except first and third pillar systems, pay-as-you-go schemes, book reserves, small and statutory schemes. Member states may include third-pillar schemes under the directive. As far as I know, no member state has announced that it intends to use this option. This means that the organisations that do come under the directive are few and concentrated in a small number of countries, mainly the UK, Ireland, the Benelux and Scandinavia. In principle, this restricts the effects of the directive.
We don’t know how its effects will play out in the future. The directive opens the possibilities of fully funded second-pillar schemes operating from one EU member state and covering another. In theory, this means that IORP may become available in all member states, even if there is no local tax legislation to support them. They may not reach the full tax advantages of EET, but should be able to realise significant tax advantages, at least on investment returns. Since IORP markets tend to have a small number of very large schemes, the possibility of a rapid international expansion, probably preceded by a slow start, exists.
An important initial effect will be the requirement of a cover ratio of 100% at all times. Investment group JPMorgan estimates from May 2004 show European (ex-UK) funds have a deficit of 86% (95% for the UK). The IORP directive demands that a deficit will be tolerated for only a limited time and a recovery plan must be drawn up.
Importantly, it does not give a minimum recovery period. This allows for a made-to-measure recovery plan. Recovery plans will tend to favour bonds over equity and frown on volatile asset categories, such as commodities and private equity.
A secondary effect may already be in the pipeline. A sub-group of CEIOPS, an advisory committee of the European Commission, will eventually take up the issue of the chance of undercover funding. This may drive up cover ratios considerably. The Dutch experience is that a requirement of 99.5% can lead to a target cover ratio of up to 170%, while even 97.5% will amount to a target cover ratio of around 135%. High cover ratios, coupled with a limited period of ‘recovery’ will be a strong push from DB to DC. However, individuals are far more conservative in their investment choices than a professionally governed pension fund, even taking into account that for individuals, a lower risk profile is appropriate and that individuals nearing the age of retirement need more bonds in order to be liquid. These effects will therefore also favour bonds.
The lack of real investment restrictions means a liberalisation in many countries. However, the directive covers only a limited number of member states and as states already have a relatively liberal investment control policy, this will not lead to important effects. Yet, if IORP schemes do proliferate in the future, non-IORP schemes with less efficient asset allocation may be pushed away from bonds.
Overall, the picture that emerges slightly favours bonds initially. Longer-term effects may well be to the advantage of more volatile asset categories.
Peter Kraneveld is specialist adviser for international affairs at the PGGM pension fund in the Netherlands.