The 2010 EU Green paper on the future of pensions sparked many debates in the industry about the pros and cons of applying Solvency II to pensions.  Following this publication, the European Commission asked EIOPA for advice on an EU-wide legislative framework for IORPs (Institutions for Occupational Retirement Provisions) in April 2011. EIOPA has since published a second consultation on ‘draft responses to Call for Advice’ currently expected to close on 2 January 2012.

Many have expressed concern regarding possible implementation of the draft proposals contained in these documents. Speaking in his capacity as chair of the NAPF, Lindsay Tomlinson voiced concerns that a Solvency II regime applied to pension schemes will have the effect of restricting pension schemes’ freedom to invest, suggesting that pension schemes should be growth investors.  Many have interpreted this ‘restriction’ as having the effect of prompting an exodus from equities to bonds. Another concern is the burden of potentially yet another funding basis – no doubt prompted by the reports of spiralling Solvency II costs in the life sector - allegedly some companies have already spent  over £150 million on Solvency II implementation.

While this debate continues, we should perhaps pause and ask ourselves -- are we already approaching a theoretical Solvency II regime on pensions?

Mapping Solvency II onto the existing pensions framework

In order to understand how far we are currently from a possible Solvency II regime, let’s summarise what Solvency II for insurers looks like, and how that potentially maps onto the pensions world.

A high level summary comparing an insurance regime and a pension regime are set out in the diagram below:

• Pillar I – covers the quantitative requirements – in essence, what is the value of your pension liabilities and how much risk is there in the scheme?
• Pillar II – covers the qualitative requirements which will require a clear robust governance structure as well as a risk management process in place.  In pensions language, this translates into pension scheme trustee governance, trustee knowledge and understanding and the risk register, to name a few.
• Pillar III – covers disclosure requirements to regulators and members. This translates into disclosure of pension scheme’s annual Trustee Report & Accounts and Annual Summary Funding Statement to all members.

Comparing the current DB pension system in the UK with the insurance sector, one may even be convinced that the two sectors are not really under a very different regime. Most of the contentious points about applying a Solvency II type regime on DB pensions are about Pillar I and not about Pillars II and III.  

The devil is in the detail

Pillar I has caused most controversy as on the face of it,  a Solvency II approach will require pension schemes to operate on a much stronger funding basis as well as holding additional capital against investment risks and other unhedgeable risks.  However, this scenario might not arise as the Call for Advice has made a clear distinction between the schemes which are underwritten by a sponsoring employer and those which are not. The implication is that schemes with a sponsoring employer (which apply to almost all schemes in the UK) will be able to allow for the recourse to the employer as a backing asset. In addition, it may be possible for credit to be taken for the presence of the PPF in some form. We are of course far from getting the details on paper, but for the sponsors who are worried about the funding implications of Solvency II on pensions, the reality of the situation might not be  as grim as it sounds.

What’s changing: the wider implications

Apart from the IORP directive, other regulatory bodies continue to move forward in the area of deriving a platform which better reflects risks taken by pension schemes.

One such change is the PPF levy framework for 2012/2013. Within this framework, part of the PPF’s main objectives in respect of measuring investment risk is as follows:

1. to reflect the potential volatility of a scheme’s investment strategy in thelevel of risk-based levy charged; and
2. to give schemes that have adopted de-risking strategies the opportunity to obtain appropriate credit for these risk reduction measures.

Practically, this means that for the 2012/2013 levy year, schemes with liabilities above £1.5 billion will have to carry out a Bespoke Stress Calculation on a mandatory basis. But adopting a more risk-based approach is very much in line with the principles of Solvency II and the PPF’s levy framework will hopefully act as a catalyst to better risk management practice for pension schemes without the bureaucratic burden of onerous legislation.

Conclusion

With the other changes, driven by different authorities coupled with the review of the IORP directive, it is not a matter of lobbying against whether Solvency II should be applied to pensions; one would argue, it is already in place, simply badged up under a different name.

A constructive way to deal with the possibility of applying Solvency II to pensions is to learn our lessons from how Solvency II implementation on insurance is working and select the elements which have worked well and avoid the pitfalls for pensions.

Different parties within the pensions industry are currently lobbying about (mostly against) Solvency II on pensions. If we are not careful, some of the strong messages may get lost in politics as a result of highly negative voices about the IORP directive. Initiatives such as the PPF levy framework to include investment risks are good practice to ensure that schemes are rewarded for managing risks. As we see from the current financial crisis, a system whereby institutions are treated equally regardless of the level of risks they run means that the good ones will forever have to bail out the bad ones.