Getting solvent

Christine Senior explores how the possible introduction of ‘Solvency II for pensions’, could affect pension funds’ investment strategies

The European Commission’s announcement in May that plans to apply Solvency-II style capital requirements for DB schemes were to be put off indefinitely brought some relief to hard pressed pension managers. But the threat of such regulation still looms over pension schemes. If not immediately, at some time in the future, strict solvency rules could be introduced. The European regulator, EIOPA, certainly wants it to happen.

EIOPA is currently developing the concept of capital adequacy for pensions. But the decision as to whether to proceed with new solvency rules will rest with the next commissioner for the internal market, the successor to Michel Barnier, who takes office towards the end of next year. A lot depends on who that is.

On the back burner
National Association of Pension Funds (NAPF) EU & International policy lead James Walsh thinks pensions currently have far more pressing priorities than capital adequacy. “Sixty million European workers don’t have access to workplace pensions. That’s a key challenge the European Commission should be addressing, rather than imposing new rules on existing schemes.”

Pension schemes will still face the imposition of other less harmful demands - those which address governance, and transparency – in the revised IORP Directive currently in preparation.

Tougher capital adequacy rules would force schemes to hold more capital as a protection to cover holdings in riskier assets. In the UK many believe it would spell the end of defined benefit schemes, which are on the path to oblivion as it is.

Walsh thinks it quite likely that new capital rules will remain on the back burner. By November 2014 the IORP Directive mark two will have been finalised. “Almost immediately to have another IORP Directive mark three including capital adequacy would be surprising,” he says.

J.P. Morgan Asset Management European head of strategy group Paul Sweeting also believes the odds are against it. Sweeting has calculated that the opposition is strong enough to block efforts to introduce legislation.

“EIOPA have said they would like to bring it forward at some point in the future. We don’t think they would get it through even when voting rules change in a few years’ time. There is too much opposition to those sorts of changes – from the UK, Germany, Netherlands, Ireland and Belgium.”

The same rules
But some industry representatives feel it would be no bad thing if pension schemes were subject to the same rules as insurance companies. Are they not both in the business of providing the same product – pensions – for the public?

Cardano UK CEO Kerrin Rosenberg says: “Whether you are a member of a pension fund or have bought an annuity from an insurance company, the question is: should the regulator try to give the same degree of protection? I think that’s a valid question. From the person in the street’s perspective if you are an annuity holder or if you hold an annuity from a pension company or from your pension fund, as far as you’re concerned you are getting a monthly pension.”

And Koris International CEO Jean-René Giraud says capital adequacy is in any case the direction of travel for other financial market participants, so it probably will happen for pension funds too.

“Capital adequacy rules are in place for banks, they’re well advanced for insurance companies. It reflects a modern risk management approach. Most Nordic and Dutch pension funds, even though they don’t strictly speaking have capital adequacy rules, operate in a comparable quantitative framework when it comes to the monitoring of their funding ratio, marking to market their assets and assessing how well they match and cover liabilities. The whole industry is moving towards this kind of approach. I wouldn’t be surprised if this happens for pension funds as well.”

New strategies?
So what might happen to pension plans’ investment strategies, if new solvency rules are imposed on them? Schemes need to invest in risk assets to make good their deficits and cover liabilities, but the requirement to hold buffers of cash to cover their risk assets would pull them in the opposite direction, to the safer haven of bonds.

One theory is new rules might not have much impact on investment. Rosenberg says his clients have other priorities at the moment that push concerns about the effects of capital adequacy rules way down their agenda.

“Most schemes are poorly funded. If you are a well-funded scheme and Solvency II-style rules for pensions are introduced it could lead you to change what you are doing. If you are poorly funded you are simply trying to generate returns and take as little risk as necessary. So whether or not new rules come into place, because you are so far under water, that’s not really going to influence your behaviour.”

Old Mutual Asset Management head of non-US distribution Olivier Lebleu says the mark to market demands of any new solvency rules would not mean much change in the way pension funds operate, because the regulator already makes strict demands on pension schemes to ensure they get back to full funding.

“Pension schemes have been investing in more and more bonds to have matching assets from a cashflow perspective to the liabilities they have to pay out. Solvency II-style rules would only increase that by requiring even less risk taking. If you think of where we are in the interest rate cycle in this country and most of the developed world, buying more bonds doesn’t strike anybody as a good investment idea. Buying more bonds today is taking a huge valuation risk.”

Risk reduction
It is not even just capital adequacy rules that reinforce the move away from risky assets. JLT Pension Capital Strategies managing director Charles Cowling says governance and transparency, which will be included in the IORP Directive, will themselves drive pension schemes down the route of risk reduction.

“As you highlight risk so the pressure mounts to reduce risk,” he says. “If more criteria are introduced around how much risk a pension scheme should run, it will encourage less risk-taking among trustees. The more transparency there is, the more obvious it becomes that liabilities should be managed down, and the risks transferred to an insurance company.”

Cowling thinks the existing trend for pension funds to move out of equities and into bonds will gather pace.

“Every time you notch up the pressure on risk management, on disclosure, and even talk about solvency it nudges trustees - as and when they can afford it - to put a bit more into bonds. The trend of the last five to six years out of equities into bonds will continue.”

Search for alternatives
But holding government bonds at current meagre yields would be disastrous, so the search would be intensified to find alternatives to gilts that offer higher returns.

Sweeting says: “Depending on the way Solvency II-style rules would be implemented it might push schemes more towards corporate bonds than government bonds, if there was some sort of liquidity premium there. But risky assets would be off the table. It might be that like insurance companies pension schemes would focus more on expected return and the amount of capital you need to hold for that return. There would be much more focus on sponsor strength and its impact on a pension scheme’s ability to take risk.”

Lebleu also highlights the need for alternative means to get income without buying bonds.

“I think it will mean more real assets in portfolios and fewer financial assets,” he says. “I think bonds and equities will go down or stay where they are. One of them will be used as source of funds to by real assets to generate steady cash flows. That can mean property, infrastructure, or natural resources. The existing trend in that direction will accelerate.”

Cowling agrees. Pension schemes will seek out higher returns with less risk from both their growth and liability matching assets. For growth assets they might turn towards infrastructure, diversified growth funds and property, he says. “On the bond side we have seen interest and appetite in secure loans and other bond-like markets where you earn something better than you get investing in gilts.”

Written by Christine Senior, a freelance journalist

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