Implementation of the European Union's (EU) Solvency II framework directive could damage pension provision when it comes to annuity business, warns Mercer.

The financial consultant has said that Solvency II must been approached with caution in the UK, due to the country's 'unique' reliance on annuities for retirement income and scheme security. Solvency rules contained in the directive could put pressure on annuity costs if providers' current reserving requirements are found to be inadequate.

Deborah Cooper, head of Mercer's regulatory group, explained: "If Solvency II results in improvements to the existing regime, then it should be welcomed. However, some of the proposed capital requirement tests seem ill suited to annuity portfolios, which have stable long-term cash flows and will only be gradually impacted by increases in longevity. Solvency II should be introduced in a way that is sympathetic to the different risks being underwritten and that avoids damaging the UK's pensions industry."

Solvency II also requires that insurers hold sufficient assets, with a no more than 0.5 per cent chance of failure in each 12-month period. Failure will be measured as a shortfall against an insurer's technical provisions, which consultation documents from July confirm that this should be measured using a risk-free rate of interest.

Alan Baker, specialist in pension fund de-risking at Mercer, added: "Trustees should not be pressured into a knee-jerk reaction and rush into buyout or buy-in arrangements before Solvency II comes into force. While buyout strategies are valid for many schemes, there are alternative options open to trustees and companies looking to manage longevity, inflation and investment risk."

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