Even in a watered-down form the potential application of Solvency II to European occupational pensions could have a significant negative impact on corporate cash flows. This initiative’s insurance-style funding requirements could negate the progress made by European companies in managing pension liabilities in recent years. EIOPA’s first Quantitative Impact Study (QIS) should provide more clarity, but not until later this year.
While it is hard to see the change not having a material negative effect on corporates, the limited detail on how Solvency II might be applied to pensions has led to widely varying estimates. Coming up with a workable methodology is no simple task because of the sheer variety of private pension arrangements in place in different European countries. EIOPA’s solution is a “holistic balance sheet” that takes into account intangible factors such as pension protection insurance schemes like the UK’s state-sponsored Pension Protection Fund and – where the ultimate responsibility to fund a scheme falls on an employer – the strength of that employer’s covenant.
These intangibles appear on the asset side of the balance sheet along with financial assets held at market value and, potentially, an asset representing payments to be made into the scheme as part of a recovery plan. Giving pension schemes credit for all potential sources of funds is a clever way around the problem of how to deal with different scheme arrangements – although valuing the non-financial assets will be tricky, to say the least.
There is less of a silver lining where liabilities are concerned. The aim of putting occupational pensions on a level playing field with insurance companies makes it very hard to avoid making pension schemes compute liabilities in the same way as an insurance company, in which case liabilities will rise considerably.
One significant change under Solvency II is that insurers discount liabilities using a risk-free interest rate, rather than the rate based on expected return on assets currently used by many schemes in countries such as the UK. However, there is an ongoing debate about adjustments to the liability discount rate under Solvency II and how the impact of spread volatility can best be contained, and this may have a significant impact on liabilities.
A challenge may also arise from the need for additional assets as a capital reserve buffer to ensure the scheme remains fully funded in the face of asset price volatility. Under current proposals for insurance companies under Solvency II, this requires schemes to remain fully funded to deal with all possible outcomes to a conservative one-in-200 probability. Depending on the mix of assets this buffer could equate to a significant proportion of liabilities.
A further key consideration is how assets and liabilities will interact. EIOPA tentatively sets out that a best estimate of liabilities should at least be covered by financial assets, although the latter may include a recovery plan. But it also says that current plans may be subject to revision following the QIS.
So we are left waiting for the QIS. In the meantime, the approach taken by most lobbyists – assume the worst and lobby on that basis – may be prudent.
