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Solvency II on pensions – a necessary evil?

Tue, 03 Jul 2012 14:51:48 GMT

In February 2012, the European Insurance and Occupational Pensions Authority (EIOPA) published its final response to the European Commission’s Call for Advice on the review of the IORP Directive 2003//41/EC, now commonly known as ‘Solvency II on pensions’.

Much of the subsequent debate revolves around a possible increase in pensions funding and compliance costs - for defined benefit pension schemes in particular. In the UK, various anti-SII lobbying groups argue that the UK already has strong governance structure in place such as the sponsor’s covenant to protect its final salary pensions, and that further protection from Europe is unecessary. So while many DB schemes in the UK are underfunded, much of the gap between the scheme’s existing ring-fenced assets and the amount needed to pay full benefits is safeguarded by the sponsor’s future contributions.

Funding costs aside, very few can really disagree with the concept of a Holistic Balance Sheet (HBS), first introduced in the EIOPA Call for Advice consultation. An HBS approach would potentially require, at least, the quantification and disclosure of the size of the sponsor’s covenant which is currently ‘off balance sheet’ against the full cost of funding a pension scheme, on a long-term economic basis. This would bring transparency to stakeholders regarding the security of the pension benefits. An illustration of a possible HBS is set out in figure 1.

Figure 1 - A possible Holistic Balance Sheet

One of the challenges of adopting a Holistic Balance Sheet approach is in being able to quantify the sponsor’s covenant in a market-consistent manner. It is undoubtedly an interesting problem, but one that need not be so complex that it defeats us. (The main focus of this article is not about capital requirement, but it is worth mentioning that as the Solvency Capital Requirement is defined using a Value-at-Risk (VaR) for the market-consistent balance sheet,  once we have a way of calculating the market-consistent balance sheet, we can then build a VaR estimate by re-valuing that balance sheet in tail scenarios).

Techniques already employed in insurance solvency assessment have direct relevance to solving the problem of valuing the sponsor covenant. Not only do these mechanisms give an objective method of quantifying the employer covenant, they could also provide an improved governance structure in which trustees and sponsors have a clear strategy on if and when employer contributions will be paid as market conditions change. The credit-riskiness of contributions, if deferred, can also be quantified.

Market-consistent valuation of the sponsor covenant – a possible approach

Another method of putting a market-consistent valuation on the sponsor covenant is to examine the contribution strategy in order to identify how the full range of possible future financial and economic paths, as well as how the credit-riskiness of the sponsor will behave over time. The approach suggested below has parallels with how insurers incorporate future management actions into the valuation of market-consistent balance sheet in Solvency II.

Firstly trustee and sponsor need to agree a contribution strategy. This sits well with flight path discussions which are already in place with many trustee boards. The HBS approach will simply formalise what is already in place. A very simple example of a possible contribution strategy might target, say, 80% funding level on an economic basis and spread any deficit over a five-year period.

Next, we use a set of risk-neutral economic scenarios to produce the joint behaviour of the paths of market returns and sponsor defaults. These scenarios are then used to produce the cash flows in accordance with the contribution strategy, derived from the flight path discussion, to produce a market-consistent valuation of the sponsor’s covenant.

By way of an example, figure 2 shows the results of the sponsor’s covenant by looking at sponsors with a range of credit-worthiness. To test the extreme, funding strategy 1 assumes  that the sponsor delays contributions until all assets are fully exhausted, and funding strategy 2 assumes  that the sponsor will pay the full buyout cost every year should a deficit arise.

Figure 2 - A comparison of funding strategies

Based on figure 2 above, we can make a number of observations:

  1. The larger the contribution payments are assumed to be, the larger the value of the sponsor covenant will be.  (Where contributions are paid at the end of every year to fund to full buyout (blue line), the overall value of covenant is higher especially for a risk-free employer.
  2. The more credit-risky the sponsor is, the smaller the value of the sponsor’s covenant will be.

The two observations might be obvious but they demonstrate that this technique is useful in terms of quantification of the sponsor’s covenant. The conclusions are also in line with what logic tells us should be true.

Key benefits of this approach in quantifying the sponsor’s covenant within the holistic balance sheet framework

A Holistic Balance Sheet approach is indeed more transparent but also brings with it interesting challenges from a financial modelling point of view.  In addition, our suggested approach, set out above, on the quantification of sponsor’s covenant has additional benefits which extend beyond the HBS framework of:

  • Clarity of value when contributions are deferred – this method allows both the quantification of time value of money as well as the credit-riskiness of delaying contributions.
  • Lends itself to having a governance structure whereby trustees and sponsors are clear about their contribution strategy – when contributions are expected to be paid under different financial outcomes, both the movements as a result of the scheme’s funding position as well as changes to the sponsor’s financial circumstance.

Both of the above seem to me to have the benefit of killing two birds with one stone. More importantly, it honours the true spirit behind Solvency II for putting in place an HBS– better financial management of the pension scheme and ultimately more controlled decision-making.

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