The importance of keeping an eye on developments in Europe is obvious. We already have examples of two EU regulatory initiatives that are pretty much a certainty to put up the price of annuities in the next few years the Solvency II directive and the gender directive and the related European Court of Justice ruling banning gender based pricing.
So while EU legislation may appear to wend its way slowly, difficult to track as it meanders through various institutions, its ultimate impact can be serious.
The European Commission has big plans for more pension legislation and experts say it has found new impetus emboldened by the financial crisis. There are several drivers. One is a determination to make significant financial institutions, which to some in the EU includes big pension funds, safer and more resilient.
As part of a green paper issued last year, it also raised concerns about a host of general retirement issues such as their impact on public finances, aging populations, whether contributions are high enough and if we face pensioner poverty for a large section of future retirees.
There are big fears particularly when it comes to defined benefit pensions that any proposed ’cure’ could lead to the swifter demise of the sector. There may also be more attention paid to defined contribution plans including, according to some experts, what they charge, though there is some debate about how much any new legislation will involve itself with DC and whether the UK would already meet many requirements anyway.
Change could come in a planned update of the Institutions for Occupational Retirement Provision directive (IORPs) while other issues are to be addressed in a White paper due in November to follow on from last year’s green paper.
The Commission is taking evidence about the updated directive in two phases. One has already taken place covering the Directive’s scope and stipulations on governance, internal controls and the definition of ’fit and proper’ persons allowed to run pension schemes.
But the second tranche of draft advice which could include a lot of the most controversial issues, starts on the 25 October and closes in December. Many concerns have focused on the fact the Commission has asked the European Insurance and Occupational Pensions Authority (EIOPA) to use Solvency II as the basis for updating the directive, which could put new capital requirements on DB. What isn’t clear is how far it could stray into the territory of DC.
It is also possible the Commission could take the stalled pensions mobility directive off the shelf though this has foundered in the past over fundamental differences between members and could do so again, so it may seek to incorporate improvements in pension portability between states in its existing work. This is a complicated process made more complicated sometimes by the way UK institutions interact. The strange Parliamentary dance which often occurs when these issues are debated is illustrated by the following exchange.
Labour’s Lord Myners, once Labour City Minister, the former Gartmore chairman and of course, a former Government pension reviewer was prompted to ask about the EU’s competence levels in terms of pensions in the House of Lords last year.
The double whammy to liabilities means the cost of providing annuities will go up and firms will not have muchchoice but to pass these costs on to consumers. It would hurt an existing business as well.
Myners asked: “What assessment have the [Government] made of the extent of the European Union’s competence in the area of pensions policy; and in light of this what is their assessment of the proposals set out in the European Commission green paper Towards Adequate, Safe and Sustainable European Pensions Systems?”
Lord Freud, the Coalition minister for welfare reform, replied: “Pensions systems are within the competence of individual member states. There is an EU interest in the aspects of occupational pension provision and supervision that are concerned with the enabling and supporting of free movement of persons and services. The European Commission’s Green Paper was a consultative document only.”
Technically, this is probably accurate but that doesn’t quite represent the situation because European initiatives can certainly make an impact. The EU might not have direct responsibility for pensions as Freud says, but it can use other powers granted for example under single market legislation to bring about change.
That ability to change things for better or worse is illustrated by the impact of Solvency II on insurers.
“We reckon Solvency II will put up annuity prices by 10 to 15 per cent if fully implemented. We think it will be implemented and already the insurers are pricing some of the likely impact into their products. Whether we need the second tier of protection annuitants are already better protected than elsewhere in Europe is open to question,” says First Actuarial director Henry Tapper.
Reinsurer RGA UK’s financial risk and capital actuary Garth Lane says: “There has been a lot of dissatisfaction among the big annuity providers with aspects of Solvency II. That is primarily because solvency two is a risk neutral framework but most companies that write significant amounts of annuity business have matched their liabilities carefully, investing in higher yielding assets. But because they have a degree of credit spread in them or a degree of optionality if they have gone into the derivatives markets, this is not taken into account. Under current rules they would be using a higher discount rate, under Solvency II is could be lower.”
Lane adds that capital could also be higher under Solvency II because insurers have to take into account the risk of a bigger hit on longevity too.
He adds: “This double whammy to liabilities means the cost of providing annuities will go up and firms will not have much choice but to pass these costs on to consumers. It would hurt existing business as well.”
Rearguard actions are possible however but they often only offer slight improvements.
The important thing is not to increase the cost of compliance in way that doesn’t translate directly into members benefits
Lane says there is strong industry lobbying backed by the Government and the FSA to allow at least a certain amount of these credit spreads. He says a compromise has been put forward in the latest EIOPA quantitative impact study that might allow a permitted 100 per cent of a liquidity margin on a fixed notional model basis. But that would only impact annuity business in payment, not new annuities.
It all demonstrates why the next possible application of Solvency II to the defined benefit pensions sector is worrying the UK. Ian Neale, information specialist at Aries Pensions says: “There is a lot of apprehension in the UK, that what might emerge might do a lot of damage. Alarms bells were set ringing at the suggestion that solvency II would be an excellent basis for a new IORP directive and that betrayed a fundamental misunderstanding.” James Walsh, the NAPF’s senior policy adviser, workplace pensions said that advice due to be published on 25 October, will give a better indication of European thinking.
“That is the tranche that is going to cover the really hot issue. Should there be a fund solvency regime for pension funds? We are extremely concerned. We dispute that you should try and take elements of Solvency II and slot them into pensions. We don’t think you can apply something from insurance to pensions.”
“Pensions have a specific regime, but if you look at the call for advice the commission sent EIOPA, it says please take Solvency II as a framework. We are energetically lobbying the European Commission. The UK government has taken a robust position. The interesting thing is that the social partners, CBI and TUC are also taking the same position. It is a matter of great concern.”
The costs could prove quite spectacular which is perhaps why UK groups, divided over many other things remain firmly united in their opposition. Standard Life head of pensions policy John Lawson suggests that some continental insurers, for example in France, might see DB theoretically in competition with them, hence the demands for a level playing field.
UK insurers don’t share this view or see any comeback for DB. But Lawson says the Commission’s action could hasten their end in rather spectacular fashion. “If the directive forces DB to hold solvency capital, maybe upping their funding 25 or 30 per cent, you are talking about a big impact on the economy, maybe as much as £300bn. It is like asking them to put in ten year’s contributions, so I don’t think Solvency II will ever fly. The Government would be mad to let it happen,” he says.
Walsh adds: “The reason why we are bothered is that with more demanding requirements, the people who stand to lose out are the members. It could accelerate the end of some DB schemes. The Commission could end up cutting off its nose to spite its face and could end up with less generous, less secure pension schemes.”
Neale adds: “The important thing is not to increase the cost of compliance in way that doesn’t translate directly into members benefits. In other words, you can increase member security massively. But one has to be proportionate.”
It is obvious why a lot of attention is focussed on DB. But could the Commission make life more difficult for DC schemes?
Ward believes the white paper will cover DC and this could be welcome. He says the green paper made some sensible comments about the problem of all the risks being with the member. “We would like to see new forms of pension schemes with scale, where risk sharing is possible. Though it is more a matter for national authorities, if the EU made the right sort of noises to promote risk sharing, and innovative forms of DC, it could be a positive form of contribution.”
Details may come in the tranche of consultation due to start in late October says Tower Watson senior consultant Mark Dowsey.
“The next consultation deals with thornier issues such as should there be any investment restrictions, disclosure of information to members, and a big one for DB the capital adequacy elements of a solvency scheme.
“That is not to say there isn’t a capital adequacy element for DC. There is certainly a discussion that an additional risk module of Solvency II could be applied to DC arrangements. They are prone to operational risks, fraud, failure to comply with member wishes in terms of switching. Risks may differ from DB but the potential impact is arguably higher under DC. With a failure to invest in time, the member is bearing the risk, whereas with DB that is increased costs for the employer.”
Lawson sees a possibility that even charges could be considered.
He says: “Europe is hugely risk averse and likely to remain so for years. They might look at DC and ask ’are we right to let people invest in funds that can fluctuate wildly?’ But for a lot of this, TPR is ahead of the game.”
Lawson says there are other issues that could impact on DC, such as fit and proper rules for people who manage schemes, investment rules and rules around the supervision of funds. However there just might be cost regulation. Were this to happen corporate advisers should largely be protected due to the RDR adviser and consultancy charging reforms.
But it is not a certainty. “There is talk of cost regulation to ensure all costs are fully and transparently disclosed. They are talking about unreasonableness tests, capping fees, requiring competitive bidding, centralisation, clearing houses. There are also things the pension minister has shown interest in. Some of these things might concern advisers in the DC market. There might be scrutiny on charges. With adviser or consultancy charges if they are taken into account, it could cause problems but it is too early to say,” says Lawson.
If there were going to be any issues, there is some time, Dowsey says. The November white paper has a December close of play on the call for advice including the difficult defined benefit issue and possibly measures of interest to DC.
He says IORP version two might be published in the third quarter of 2012. If it is then batted between the Council of Ministers and European Parliament it can take a year in a fast process, 18 to 24 months for a slow one. Implementation can take a couple of years and some elements might have their own transition element. “So we are looking at 2016 at the earliest,” he says.
However he stresses the further the process gets, the harder it is to change something the UK pensions industry would do well to consider in light of what Europe has done to the annuity market.