Solvency funding in pension schemes

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2 Solvency funding in pension schemes The application of solvency regimes to European pensions Lindsay Goundry, Jane Beverley, Jacqui Woodward, Joanne Livingstone and David Cule December 2007 We are grateful to the following for their advice and assistance in preparing this report: Neil Carberry, Aled Davies and Katie Sokolowski of the CBI Philip Jones and Mike Harris of The Hundred Group Pensions Working Party Nigel Peaple of the NAPF Brendan Mulkern of the Universities Superannuation Scheme We are also grateful to the following for their assistance in relation to some of the international dimensions: Henk Bets of Confident BV Jeppe Jørgensen and Anne Buhl Bjelke of Bech-Bruun The Pensions Regulator Finally we would like to thank the participants at a Punter Southall round-table on Solvency II held in July 2007, especially our speakers: Jeanette Holland of Baker & McKenzie, Barthold Kuipers of the ABP Pension Fund, Henk Bets of Confident BV and Gerhard Haschke of BVE GmbH.

3 Executive Summary This paper discusses the effect of various funding regimes for defined benefit (DB) occupational pension schemes. It considers why these might differ from those applying to insurance companies and, in particular, why an insurance-type solvency regime would be inappropriate for pensions. It also explores the implications throughout the EU if a solvency regime were to be applied to pension schemes. The paper should be considered against the background of Solvency II (the new insurance company funding regime) and any future review of the Institutions for Occupational Retirement Provision (IORP) Directive, together with the EU s aims of encouraging private pension provision and reducing the reliance on state benefits, developing an effective single market and ensuring protection for members and beneficiaries. Although it has been confirmed that Solvency II will not be applied to occupational pension schemes, a prescribed funding standard such as a solvency regime may still be imposed through an amended IORP Directive. A solvency regime for pensions would mean the use of a prescribed prudent basis to value liabilities, together with additional solvency margins. This may result in funding requirements similar to those of Solvency II, although alternative solvency regimes are possible. Qualitative requirements may be imposed in addition, similar to the second and third pillars of Solvency II. Insurance and pensions Insurance and pensions are fundamentally different and have different economic and social objectives. They should therefore be subject to different funding requirements and regulatory regimes. The key difference is the covenant of the sponsoring employer to pension schemes. A pension scheme generally has recourse to further income if needed in the event of adverse experience (assuming the employer remains solvent). Additionally guarantee funds operate in some countries (notably the UK and Germany) which provide security in the event of the sponsoring employer s failure. This reduces the need to hold solvency margins in the same way as insurers must do. More generally, pensions are deferred remuneration, designed to provide an income in retirement. Schemes do not operate on a competitive or commercial basis but rather on a not-for-profit basis. Schemes are often closely linked to social and labour law, and may be formed through collective bargaining or labour agreements, with membership generally offered across a whole workforce and at the same benefit levels. It is often possible to change the benefit promise over time and schemes operate with a long time horizon, enabling investment in more illiquid and return-seeking assets. In contrast an insurance contract is a legally binding agreement that operates on a competitive and commercial basis, with an insurer aiming to maximise profits (or bonuses). Benefits are generally fixed at the outset and determined at the individual policy level. Time horizons for most classes of business are fairly short, resulting in a need for assets that are liquid with low volatility. One argument for applying a solvency regime to pensions is that harmonisation of security levels will avoid regulatory arbitrage and reduce barriers to cross-border provision. However, any barriers are more likely to come from differences in social and labour law and tax systems, meaning that any market in cross-border provision is likely to be limited to investment management. It should also be noted that studies suggest that very few crossborder schemes have been set up since the implementation of the IORP Directive, which was intended in part to facilitate the introduction of such schemes.

4 Impact on EU Member States On a pan-european basis, future provision is likely to be affected, since DB provision is likely to become prohibitively expensive in all countries. This could result in a general move towards DC provision which typically provides a lower level of benefits. The impact of a solvency regime might well be to inhibit the development of new pensions provision in those Member States (especially the newer Member States) that have yet to develop significant supplementary pensions. Again this is in contrast to the EU s aim of adequate retirement incomes for all and promoting the affordability and the security of funded and private schemes. Beneficiaries themselves will suffer as a result of a solvency regime. The impact of a solvency regime on individual Member States is likely to vary widely due to the different pensions systems that exist. In the UK, technical provisions for a typical scheme could increase by around 90% compared to those on an existing funding basis. The impact for the FTSE350 is estimated to be an increase in technical provisions of a similar magnitude, which represents over 15% of the market capitalisation of FTSE350 companies. Employer contributions are likely to need to increase significantly in order to fund the increased deficits. This could increase the number of employer insolvencies, and we may also see schemes and employers looking to reach agreements with the Pension Protection Fund (PPF). For surviving employers, balancing increased contribution requirements with investment in the business could be difficult, and we are likely to see an increase in the number of schemes closing. Since solvency funding is likely to be at a higher level than the cost of buying out benefits with an insurer, we might expect some employers to proceed to a buyout. It is also likely that schemes will reduce equity holdings in an attempt to reduce the solvency margin. This could lead to falling equity markets combined with increased demand for bonds, which would in turn lead to lower bond yields. A consequence of this is a spiralling effect, whereby technical provisions would increase and assets would reduce, further increasing deficits and contribution requirements for remaining schemes. This would affect other investors in the equity and bond markets, including insurance companies and defined contribution (DC) pension schemes. Future pension provision is likely to be DC in nature, which typically results in lower benefits as a result of lower contribution rates (a pension of 30% to 40% of final salary might not be uncommon, compared to a common target DB pension of 67%). The impact of a solvency regime on members could be serious: we would see accrued benefits reduce where schemes enter the PPF following employer insolvency; this, combined with lower benefits from future pension provision as described above, would result in members receiving a lower income in retirement. The PPF levy could reduce because higher scheme funding levels reduce the risk of calls on the PPF. However, we might expect an increase in claims on the PPF as a result of higher insolvency rates, which could lead to increased levies. The application of a solvency regime to the PPF, rather than individual schemes, should also be considered, although this would itself lead to higher PPF levies in order to fund the increase in PPF funding levels. In Ireland, a similar impact to the UK is likely, although the magnitude of the financial impact on schemes will differ due to the different funding regimes currently in place. One key difference is that there is no guarantee fund in Ireland, so an increase in company insolvencies with underfunded schemes is likely to result in affected members seeing reductions in benefits (possibly by a greater degree than reductions to PPF benefit levels in the UK) and, consequently, lower incomes in retirement. In the Netherlands, funding is likely to increase by between 20% and 30%. Employers will be forced to look for alternative means of reducing the cost of pension provision, such as investment strategy changes in order to reduce the size of the solvency margin. This is likely to increase demand for bonds, pushing down yields, although the impact on equity markets might be less significant since Dutch pension funds tend to hold lower proportions of domestic equities. Denmark also has a sophisticated and well-developed system of private pension provision. However, in contrast to the UK, Ireland and the Netherlands, little or no impact is expected since pension arrangements are either based on insurance contracts, in which case insurance regulations apply, or are provided by credit institutions such as banks, in which case they are viewed as savings products and different regulation applies again.

5 In some Member States, a solvency regime might be expected to have relatively little impact on existing pension provision because funded DB provision is not widespread. In some countries (Austria, France and Italy) most provision is by means of state arrangements. The Eastern European countries in general have relatively undeveloped pensions industries, giving limited scope for the impact of a solvency regime. In other countries (Finland, Germany, Sweden) DB provision is fairly common but either the benefits provided are fairly low, are limited to certain categories of employee only, or advance funding is uncommon. However, where other means of funding exist (e.g. the book reserve arrangements in Germany), it is possible that a solvency regime could be applied in due course in order to ensure greater harmonisation. In this case other Member States, particularly those where book reserving or pay-as-you-go funding is common, may see a significant impact. A solvency regime will effectively penalise those countries that already provide a substantial proportion of postretirement income through private occupational DB schemes rather than state schemes, and would place these countries on an uneven footing in Europe, which is contrary to the aim of achieving an effective single market. Existing protection for members Looking at the qualitative aspects of a solvency regime, comprehensive regulation already exists in most pensions industries and in some cases (including the UK, Ireland and the Netherlands) this already meets the second and third pillars of Solvency II, as well as providing adequate security and protection for beneficiaries. Examples are funding requirements (most Member States), investment restrictions (Ireland, the Netherlands and the UK), disclosure requirements (Ireland and the UK), governance and internal controls (Ireland, the Netherlands and the UK) and guarantee funds/insolvency insurance (Germany and the UK). This further reduces the need for the imposition of a solvency regime, particularly when combined with the security provided by employer covenant. Cost of pension benefits Analysis suggests that in several Member States, the cost of providing the same nominal amount of pension on a common funding basis varies quite widely as a result of additional benefits or revaluation which may be guaranteed or discretionary. In particular, the cost in the UK is notably higher than in Ireland, Germany and the Netherlands, reflecting the guaranteed nature of benefits such as indexation in the UK. However, other than Germany (where funding is most commonly through book reserves which have no advance funding), the cost of providing pensions is fairly similar, taking into account the benefits associated with the pension (such as indexation) and the typical funding bases used in each country. This suggests that a broadly level playing field already exists in funding, implying that there is not such a need to harmonise funding levels. Security of the pension promise is a benefit and therefore has a cost. The value of the pension promise should not be based on benefits or security in isolation, but should take both into account. Any meaningful consideration of the harmonisation of pensions across the EU should therefore allow for the relative balance between these two factors in each Member State. Conclusion A solvency funding regime applied to occupational pension schemes on a one size fits all basis and consistent with the Solvency II Directive would have adverse consequences for existing schemes, sponsoring employers and the economy as a whole in the UK, Ireland and the Netherlands in particular, putting those countries on an uneven footing with other EU Member States. More widely, it would also have the effect of impeding the development of private pensions provision across the EU.

6 Table of contents 1. Introduction 1 2. Insurance and occupational pensions 3 3. The impact of a solvency regime on EU pension systems The cost of providing pension benefits Conclusion 44 Appendix A - The UK pensions environment 45 Appendix B - Solvency I, Solvency II and the IORP Directive 46 Appendix C - Assumptions 48 Appendix D - Occupational pension provision across the EU 51 Appendix E - Glossary 53 Appendix F - References 57

7 1. Introduction The purpose of this paper is to discuss the impact of the various funding regimes that could apply to defined benefit occupational pension schemes. It considers why these might differ from those applying to insurance companies and, in particular, why an insurance-type solvency regime would be inappropriate for pensions. By solvency funding regime we mean a requirement for pension schemes to fund at a specified level, such that schemes assets are sufficient to meet liabilities with a reasonable level of confidence. In practice this would mean using a prescribed prudent basis to value the liabilities, and holding margins over and above that value, so that schemes obligations can be met even in the event of adverse experience. Additional requirements in relation to risk management, governance and regulatory supervision may also be imposed as part of a solvency funding regime. This paper must be considered against the background of Solvency II (the new insurance company funding regime), and any future review of the IORP (Institutions for Occupational Retirement Provision) Directive. When work began on this paper in early 2007, the possibility of Solvency II being applied to occupational pension schemes was very real. Henrik Bjerre-Nielsen, the chairman of CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors) advocated the application of Solvency II to pension schemes at a conference in June However, when the draft Solvency II framework directive was published in July 2007, it was confirmed that Solvency II would not be applied to pension schemes: a memorandum published alongside the draft framework stated that as part of the IORP review the commission will examine whether and how suitable solvency requirements can or should be developed for pension funds. (Source: EU Solvency II Memo/07/286.) It is expected that this review will also look at whether the IORP Directive is meeting its other aims as stated below. There have as yet been no further indications as to the likely outcome of this review (particularly in terms of solvency requirements), but it would seem that, whilst Solvency II itself will not be applied to occupational pension schemes, a solvency requirement could be introduced via an amended IORP Directive or some other means. It is also possible that the application of Solvency II to occupational pension schemes will surface again at some point in the future. We believe the EU s basic aims behind Solvency II, to ensure the financial soundness of insurance undertakings to protect policyholders and the stability of the financial system as a whole, are sound. Similarly the IORP Directive was intended to go some way to creating an internal market for occupational retirement provision [it] ensures a high level of protection for members and beneficiaries of pension funds. An indirect result of the IORP Directive may be to increase private pension provision in Member States, thereby reducing reliance on the state. However, the practical application of a solvency regime to occupational pension schemes needs to be thoroughly considered because there is a danger of unintended adverse effects. Whilst it is right that occupational pension schemes must be properly funded in order to ensure protection for beneficiaries, we do not believe that any requirements for funding should extend to compulsory solvency funding. In particular, requirements should not extend to solvency funding at similar levels to insurance companies, since pensions and insurance are very different financial products. Alternative measures exist for pensions which, when used in conjunction with sensible (but not necessarily solvency) funding methods that make allowance for the employer covenant where applicable, provide an appropriate level of security for beneficiaries of occupational pension schemes, and can help to achieve a stable single market. Such measures include suitable investment strategies, guarantee funds and good risk management practices. Further, there is wide variation in pension systems between the EU Member States and it would be very difficult to create a solvency funding regime that did not have a detrimental effect on at least some States. The most significant impact is likely to be on the UK, Ireland and the Netherlands, where a solvency funding regime would be expected to lead to much higher funding requirements for occupational schemes that would most likely be unaffordable for sponsoring employers, with potentially serious economic and social consequences. Page 1

8 The purpose of this paper is to set out in detail the arguments in support of these points. The paper begins by describing the fundamental differences between pensions and insurance in order to demonstrate that different measures are appropriate to maximise security in pension schemes, compared to insurance companies (Section 2). It will then provide analysis of the possible pan-european impact, followed by a consideration of the economic and social impact of requiring occupational pension schemes to fund to a specified solvency level, with the UK, Ireland, the Netherlands and Denmark as case studies. Some commentary is also provided on why the impact on some Member States is not expected to be significant (Section 3). We then analyse the current cost of providing benefits in various countries, and examine the factors that affect this (Section 4). Issues relating to more general aspects of a solvency regime are also addressed throughout these sections. References to solvency funding or a solvency regime in this paper should be taken in a broad context i.e. there are a number of possible methodologies in addition to Solvency II for specifying a solvency funding level using the general principle outlined above of a prescribed prudent basis with additional margins. It should be noted that several types of pension provision exist: state, occupational and individual, and each of these can be defined contribution, defined benefit, or a combination of the two (hybrid). Much of the analysis that follows is applicable only to occupational defined benefit (or hybrid) pension schemes as a result of their unique nature. It is important however that occupational provision is viewed within the overall context of total pension provision in any country. Appendix A refers you to our paper The UK Pensions Environment which provides a useful background to the issues addressed in this paper. A summary of Solvency I (the insurance industry s existing solvency regime), Solvency II and the IORP Directive is set out in Appendix B. Appendix C sets out the assumptions underlying our calculations, Appendix D provides a summary of occupational pension provision in the EU, Appendix E contains a glossary of terms, and finally Appendix F details references used. We note that the European Federation for Retirement Provision (EFRP) has recently released the results of a survey on views within the EU of the IORP Directive. This suggested that the response to date has been positive, but in practice the regime is still bedding down and it is therefore too early for any review of the Directive. At the same time the EFRP released a statement setting out its concerns in relation to Solvency II and any extension to occupational pension schemes. It is intended that our paper provides additional arguments in these areas. Page 2

9 2. Insurance and occupational pensions The purpose of this section is to describe in detail the differences between insurance and occupational pensions, thereby showing why different approaches to funding, risk management and supervision should apply. The implication of this analysis is that the level of security required for occupational pension promises is not the same as that needed for insurance contracts, and therefore funding occupational pension schemes at similar solvency levels to insurance companies or indeed any solvency level (as defined in the Glossary) is not automatically required for pension schemes. We also consider some of the existing regimes in place to protect policyholders and pension scheme members and show how these can be very effective in achieving their aims. 2.1 Insurance contracts The purpose of insurance is to enable individuals and businesses to cope with uncertainty and to manage risk. Insurance enables individuals to minimise the financial impact of adverse future events, as well as being a means of pooling savings efficiently. Businesses use insurance to protect against losses that could arise from negligence claims, business interruption and so on. On a large scale this cover is necessary to ensure that the economy functions efficiently and is resistant to the impact of adverse events. The transferral, pooling and diversification of risks by insurers is the main economic function of insurance companies. It is fundamental for the development and growth of the economy. An insurance contract is a legal agreement between the insured, or policyholder, and the insurance company. It is for a specified period of time and covers specified benefits payable on specified events. The insurer s promise to pay these benefits is legally binding. Insurance contracts operate on a commercial basis. An insurer s ultimate aim, subject to paying out claims where necessary, is to make profits for its shareholders or, in the case of a mutual company, to earn bonus for its policyholders. In contrast, pension schemes typically exist on a voluntary basis and are not profit-making. In addition insurance markets can be hugely competitive and any number of insurance companies may compete for a policyholder to purchase a particular insurance contract. Often this may be done through pricing differentials i.e. insurers reduce premiums in order to compete successfully in winning new business. The danger of this is that premiums can be insufficient to cover expected claims. Therefore, in order for insurance markets to function efficiently, policyholders need to be sure that the chosen insurer will be able to pay the benefit due under the contract when it falls due. Insurers need to be aware of the possibility of catastrophic events in most or all lines of business. This could include a natural disaster such as flooding or a hurricane, or an epidemic. Such events result in a significantly higher number of claims than would normally be expected (and potentially also larger than average claims). As well as traditional protection-based insurance contracts such as life insurance or car insurance, some insurers also offer savings products such as annuities whereby a policyholder pays a lump sum on retirement to the insurer in exchange for a guaranteed income for the remainder of his or her life. The principle of these contracts is similar, in that risks are pooled amongst a group of policyholders, so the main risk pooled amongst annuity holders, for example, is that of living longer than expected. Under both types of policy the insurer bears the risks of actual experience being worse than anticipated and hence leading to a reduction in profits or bonus. Such adverse experience could comprise a lower return on assets, a higher number of car accidents (for car insurance business) or a lower number of deaths (for annuity business) than anticipated. Page 3

10 2.2 Pension schemes Overview Pensions are intended to meet a very different need to insurance. They are primarily designed to provide individuals with an income in retirement and ensure smoothing of income over an individual s lifetime. In most countries both state and private pensions exist. State pensions are outside the scope of the IORP Directive and therefore of this paper, being simply a form of state benefit. Private pensions are those that are not provided by the state. They can operate on either a personal or occupational basis. Personal private pensions are outside the scope of this paper. These arrangements are almost always provided by insurance companies and, whilst there is no solvency margin within the pension fund itself, the insurance company is required to include appropriate margins in its capital requirements. These capital requirements will fall under the scope of Solvency II and so the issues raised in this paper are not relevant to this type of arrangement. In addition personal private pensions involve a shift in risk towards the individual and away from either the employer or the state. Any issues arising from the application of Solvency II would therefore be dealt with solely by the individual. This paper therefore concentrates on the issues surrounding occupational pension schemes and their sponsoring employers. Occupational pension schemes represent one element of the financial package with which employers remunerate employees. A pension scheme is therefore part of a labour agreement. It is an arrangement negotiated between social partners, typically an employer and its workforce, but other parties can also be involved, for example trade unions or government departments. More generally, it is a country s social and labour law, and attitude towards social protection, that determines its pensions system. Occupational pension schemes are therefore almost always provided on a group basis (i.e. for part of or for a whole workforce) and the benefit entitlement will be negotiated at the same rate and on the same terms for all employees. There are some exceptions to this, for example senior employees may be entitled to a more generous benefit, although typically this benefit will be the same for all senior employees. Occupational pension schemes are not provided on a commercial basis, since membership of a particular scheme cannot be provided without being in employment with that scheme s sponsoring employer. There is therefore no competition (in pricing or otherwise) between different occupational pension schemes in order to attract members, and individuals cannot take out their own occupational pension contract. This contrasts with insurance, where contracts are typically taken out on an individual basis, and the benefit provided under the contract will generally be negotiated on an individual basis. Catastrophic events are also less likely to affect pension schemes than insurers. In many cases additional benefits will also be provided through the pension scheme, such as life insurance, benefits for dependants on death of the primary member and benefits in the event of being unable to work through ill health. Pension schemes are often operated by a third party, for example in some countries (notably the UK and Ireland) pension arrangements must be set up under trust and are therefore required to comply with trust law. In other countries such as Portugal, pension schemes can be managed only by life insurance companies or pension fund management companies. Often a particular body or institution has responsibility for protecting pension scheme members and beneficiaries, such as the board of trustees for UK schemes, or the management board in the Netherlands. Occupational pension schemes fall into two distinct categories: defined benefit (DB) schemes and defined contribution (DC) schemes. The same funding issues do not arise with DC schemes that are experienced by DB schemes, because of the different nature of the benefit promises. It should be noted that the only way in which a DC scheme may have insufficient funds is through fraud, which is a very different issue and, in the UK at least, is dealt with separately. This paper therefore concentrates on DB arrangements. Page 4

11 2.2.2 Pension scheme funding In DB schemes however, unlike insurance companies, direct advance funding of the benefit promise does not always arise. Other forms of financing are possible, depending on the law of individual Member States. In the UK those pension schemes that are registered with the tax authorities are always funded and assets built up in advance are held separately from the sponsoring employer in a trust fund. This means that the employer (and often the employees) will make contributions on a regular basis to the pension scheme. These contributions are set aside and invested in suitable asset classes and the accumulated assets are used to meet benefit payments as they fall due. This system is also common in the Netherlands and Ireland, amongst other countries. The treatment of any surpluses that are built up through advance funding differs between pensions and insurance companies. Insurers can distribute surpluses as profits to shareholders or as bonuses to policyholders. However, because pension schemes are not profit-making, any surplus that arises must be used to provide discretionary benefits, retained in the scheme as a buffer against future adverse experience, offset against future contributions due from the employer, or returned to the employer. Practice varies depending on the legal requirements and expectations in individual countries. Outside the UK, some pension schemes are financed using direct insurance. This involves providing benefits by means of insurance contracts. This method is quite common in Sweden, where benefits in a nationwide arrangement can be funded by a central insurer. In this situation, Solvency II will apply to pension funding, since premiums to the insurer will be set at levels such that Solvency II capital requirements can be maintained. Such arrangements are therefore unlikely to be affected by the introduction of a solvency regime for IORPs (and even if insurers were required to abide by both regimes, changes in capital requirements would not be expected, unless the IORP solvency regime were more severe than Solvency II which is unlikely). In some cases book reserving is used, whereby there is no external fund. Instead the employer pays benefits directly from its cashflows and will hold a liability on its balance sheet in order to cover the value of benefit promises made under the pension scheme. This system is common in Germany. Finally, pay-as-you-go systems ( paygo ) also exist. This form of financing is very common in France where there is a mandatory national quasi-state pension scheme, but is otherwise fairly unusual for true non-state pension provision. Employer and employee contributions are used to cover current pension payments and no advance funding takes place. There is therefore little security or protection for members benefits. It should be noted that there is some overlap between pensions and insurance in the form of annuity contracts. As explained in section 2.1, an annuity is an income that is guaranteed for life that individuals can purchase on retirement from an insurance company. A pension provided by an occupational pension scheme is essentially also an annuity, albeit one that is not operated as an insurance contract. However, the key difference between an annuity and an occupational pension is that the risks inherent in providing an occupational pension remain with the employer, whereas under an annuity these risks are transferred to the insurer. 2.3 The benefit promise The benefit due under an insurance contract, in terms of both amount and timing, is generally fixed at the outset and is guaranteed. It cannot be changed once the policy has been taken out, unless both insured and insurer agree to a change in premium levels. The same does not apply to occupational defined benefit pension arrangements. In some cases, only a base level of pension benefit is guaranteed. Additional levels of benefit are discretionary and will only be paid if there are sufficient funds within the pension scheme at the point of payment in order to cover these additional benefits. A common example of this is annual indexation to a pension in payment. In the UK increases to pensions in payment were not compulsory on benefits accrued prior to April 1997 and some schemes had no such requirement in their rules. Despite this, many of these schemes have had a practice of awarding on a discretionary basis annual increases to pensions accrued prior to April However, these increases have become increasingly unaffordable and, since they are not guaranteed, schemes have been able to cease paying them, or reduce the level of increase typically granted. Page 5

12 Further, the benefit promise under a pension arrangement can generally be changed over time (subject to any legislative constraints that may apply in individual countries). This could involve a change to the absolute level of pension, changes to revaluation of pensions prior to retirement, changes to benefit indexation levels once in payment, a change in the permitted retirement age or a change to dependants benefits. This can in theory apply both to benefits already accrued (though restrictions may apply) as well as new benefit accrual. Contribution levels can be changed in order to ensure that assets and benefit promises of a pension scheme are kept in line. In contrast, it is not possible for an insurer to change the premiums under an insurance policy where these are found to be insufficient to meet expected payments or maintain the required level of reserves since these are agreed at the start of the contract. Finally, pension benefits are not readily tradable, nor can they be commuted or surrendered. In contrast a secondary insurance market exists in some countries, where insurance policies can be traded. Generally an insurance policy can also be surrendered or cashed in if it becomes superfluous to requirements. The same is not possible with pension benefits. It should be noted that in the UK there are limited situations in which pension benefits can be commuted or surrendered. For example, on retirement a member can elect to exchange a limited amount of pension for cash. When a pension scheme winds up, total commutation of the pension benefit for cash is permitted in limited circumstances. There are also some situations where sponsoring employers are offering scheme members the opportunity to sell a portion of their pension benefits for a cash lump sum (typically annual increases to pensions in payment where these are greater than the statutory requirements). However, the situations in which such commutation or surrender can arise are limited and more restrictions apply than one would generally expect to see within an insurance policy. 2.4 Time horizon Pension schemes generally have a long time horizon. Even for the more mature schemes that are no longer accepting new members and with a high proportion of pensioners, it is likely that payments will still be being made in 30, 40 or even 50 years. This period lengthens for immature schemes and those that continue to accept new members. In contrast insurance contracts usually have a shorter term. Many contracts are for a one year period only, although under some classes of business any claims arising may be run off over a period of several years. Some cover a period of several years, and other than annuity business there are not many contracts that cover a similar term to pension schemes. Typically insurance contracts are renewed on a regular basis, allowing an opportunity for the terms of the contract to be altered to reflect current circumstances, and, in the extreme, for a contract to be cancelled. Payments under protection-based insurance contracts are generally made in their entirety at a certain point in time (i.e. upon the claim event arising), giving rise to one-off sudden and, in the case of catastrophic events, potentially very large cashflows (although this differs for annuity business and some other lines where claims are run off over a period of several years). In contrast payments under a pension scheme are phased, with small payments being made on a regular basis over a very long period (potentially 20 or 30 years or more for each individual member). The consequence of this is that insurers and pension schemes must take a different view of the future. Insurers need to be focused on and have particular regard to solvency levels during the short to medium term position, with solvency over the one year time horizon being particularly critical. Insurance company assets need to be invested with this in mind. This generally means holding assets that are more liquid and can be readily redeemed to pay claims. It also involves holding less volatile assets in order to minimise short term fluctuations in the solvency position. Pension schemes instead are able to adopt a longer term outlook to investing because the short term solvency position is less of an issue: even for mature schemes where the annual pension payments are sizeable, these payments are likely to stretch many years into the future, meaning that the investment strategy over the longer term is still relevant. For immature schemes, this is even more the case. The existence of the sponsoring employer also provides additional support (see Section 2.6). This means that pension schemes can hold a higher proportion of return-generating assets i.e. assets with a higher expected return but higher risk such as equities, property and hedge funds. This is because they are better able to withstand the short term volatility Page 6

13 inherent in such asset classes. Further, pension schemes can also invest in more illiquid assets such as private equity because the short term need for cash is generally covered by income from assets such as government bonds and cash holdings, as well as contribution income. There is no equivalent to the sponsoring employer for insurance companies, meaning that they need to be able to support the risks of investing in any higher risk asset classes by means of their own resources. This is another key difference between annuity business written by insurers and pension schemes. 2.5 Participation Participation in an insurance contract is voluntary. This gives policyholders an opportunity to choose the contract that best suits their needs, and enables them to tailor the benefits, premiums and term of the contract to their needs. Consequently there is more chance of selection against the insurer. Selection arises when the policyholder chooses a policy based on his needs and where the chance of making a claim under that policy is greater than allowed for by the insurer in the pricing basis, generally because the policyholder has more information than the insurer. For example, individuals in poor health may be more likely to take out life insurance policies than those in good health. This can mean that most of an insurer s policyholders in a particular line of business have an above average risk profile, but the insurer, unaware of this information, prices them on the basis of being an average risk. Generally, however, insurers are able to allow for the most likely forms of selection in their pricing. Insurance companies operate on the basis of pooling of risk, whereby the grouping together of policyholders in the knowledge that some will need to make a claim and some will not, means that risks are shared between them. It is unknown at the outset exactly how many of these individuals will become entitled to a payment and therefore the size of the reserve is unknown. The implication of this is that larger reserves are required in order to act as a margin against possible heavy losses. In contrast, membership of a pension scheme is sometimes compulsory and is a condition of joining a particular company or industry. For example, in Austria some professional associations have mandatory pension scheme membership, and the two French schemes (ARRCO and AGIRC) have mandatory membership. The UK is also moving towards compulsion. One aspect of proposed pension reforms is that from 2012 any employer operating an occupational pension scheme will be required to automatically enrol employees into that scheme (although employees are entitled to opt out if they so wish). Even where membership is not compulsory, it is typically offered across a whole workforce and not on an individual basis. Further, in a pension scheme, payments will generally be made eventually for each member in the form of an annual pension on retirement, or alternatively a benefit (either lump sum or pension) arising on death prior to retirement (whereas in an insurance company, payments will only be made to some policyholders who meet the conditions for payment). Page 7

14 2.6 Existence of sponsoring employer and employer covenant The existence of the sponsoring employer and the employer s covenant is one of the most significant differences between insurance and occupational pension schemes and one of the key reasons why a solvency funding regime should not be applied to pension schemes. Under an insurance contract, benefits are funded by premium payments made by the insured to the insurer. These premiums are determined by the insurer based on expected claims, and must also cover the insurer s expenses and profits. If in the event of adverse experience these premiums prove insufficient then the insurer has no recourse to further income. Either benefits would need to be cut back (which would generally not be permissible by law), or the insurer s profits would be reduced leading to losses for the insurer, and reduced profits for shareholders (or lower bonuses for policyholders in the case of a mutual). In extremis this could result in insolvency and therefore large losses for policyholders (although in many countries there is a compensation scheme to cover policyholder benefits in the event of this situation arising). An insurer needs to maintain sufficient reserves in order to ensure that this situation is very unlikely. This is vital for policyholder protection. For pension schemes, the covenant of the sponsoring employer (both the ability and willingness to pay) is key. In the UK, legislation requires that a solvent employer cannot walk away from their obligations to a pension scheme without buying out all the members benefits with an insurance company. Unless they are prepared to do this, employers must continue to provide financial backing to their pension schemes. In a funded pension scheme, premiums are generally paid by means of regular contributions from the sponsoring employer and often employees. The required contributions will be assessed periodically (at least every three years in the UK) in order to ensure that they remain sufficient to meet the cost of benefits as they are accrued. If at any point there appears to be a shortfall between the assets held by the fund and the value of its benefit promises, for example as a result of adverse experience such as a fall in equity markets, a fall in interest rate or improvements in life expectancy, then the employer will be asked to increase its contributions in order to make good this shortfall. The shortfall may be paid off immediately or over a period of several years, dependent on the law of individual Member States. (It should also be noted that insurers are also required to carry out assessments of the value of their liabilities against the assets held and take corrective action where necessary, such as reducing the amount of higher risk assets held in order to reduce required solvency margins). Similar logic applies to schemes that are financed by book reserves or pay-as-you-go systems. Where book reserving occurs, then any increase in benefit payments can be covered by the sponsoring employer s cashflow. In a pay-as-you-go system, employer (and possibly employee) contributions can be increased to cover an increase in benefits being paid out. In some cases a limited amount of advance funding occurs in order to smooth the impact of an increase in the number of retirees. Consequently a pension scheme always has recourse to additional income if needed, provided the employer remains solvent (and subject to the affordability of required contributions). Pension schemes do not need the same reserves (or solvency margin) to protect members benefits against the impact of adverse experience as an insurer does, since the covenant of the employer provides the same function. It also means that, where the employer s covenant is strong enough (and provided the scheme has enough assets to meet its cashflow requirements), any shortfall within the pension scheme can be paid off over a longer period. In contrast an insurer has no external backing and any shortfall in reserves needs to be made good quickly in order to maintain short term solvency levels. Thus one of the reasons a solvency regime such as Solvency II would not be appropriate for pension schemes is that no allowance is made for the security provided by the employer s covenant. There is of course an issue with regard to the sponsoring employer s continuing solvency, since the above argument only holds true whilst the sponsoring employer is ongoing. Pension scheme members need to be protected in the event of insolvency of the sponsoring employer. This is most effectively done by means of some kind of guarantee fund. This is discussed in more detail in Section 2.7. Page 8

15 2.7 Guarantee funds Several countries have guarantee funds in place in order to protect pension scheme members in the event that the sponsoring employer of an underfunded scheme fails. The Pension Protection Fund (PPF) was introduced in the UK with effect from 6 April 2005 in order to provide compensation to members of DB occupational pension schemes where the sponsoring employer becomes insolvent and the pension scheme s assets are insufficient to pay benefits up to certain prescribed levels. In Germany the guarantee fund, Pensions-Sicherungs-Verein AG ( PSV ), pays benefits in full for those schemes where the employer has become insolvent. It is financed by annual contributions paid by employers. Benefits are based broadly on accrued benefit entitlements but with some vesting requirements for non-pensioners. However, increases to pensions in payment are not generally provided (unlike the UK s PPF). In Sweden there is a guarantee fund known as the FPG, which provides insolvency insurance for schemes that are financed through book reserves or retirement foundations. It charges a premium to companies based on percentage of the amount of book reserve. These guarantee fund arrangements remove the need for pension schemes to carry significant margins to protect the security of members benefits in the event of the insolvency of the sponsoring employer. Further, where the insolvency of the sponsoring employer begins to look like a real possibility, the funding level (or target funding level) in a pension scheme can be increased appropriately to take account of the weakening of the employer s covenant. It is also worth noting that in some countries compensation schemes exist to protect policyholders of insurance contracts. These can apply in the event of company collapse but also in the case of fraud. 2.8 Funding regimes currently in place The funding regimes currently in place for insurance companies and occupational pension schemes throughout the EU are very different, reflecting the different social and economic purposes of the two types of arrangement. The current insurance regime is governed by Solvency I and is largely based on holding additional margins on top of technical provisions (being the valuation of insurance liabilities) in order to cover the impact of potential adverse future experience, thereby ensuring that insurance companies remain solvent and able to pay out benefits as they fall due. The background to the financing of pension schemes was explained in Section 2.2. Some changes were made as a result of the IORP Directive in 2003 (see Appendix B). The intention behind these requirements was to ensure that pension benefits are properly secured. In our opinion there is no need for a further level of funding, or additional layers of complex legislative requirements, particularly given that the legislative framework surrounding the operation of pension schemes is already hugely complicated in some Member States. Further, the IORP Directive recognises the difference between schemes with a sponsoring employer, which can expect to have recourse to further capital, and those with none (known as Regulatory Own Funds schemes, of which it is thought that none exist in the UK). These schemes are required to have higher quasi-insurance funding levels, with a specified reserve required over and above the value of the technical provisions. There are also additional restrictions regarding the period during which any shortfall in funding must be made good. It should also be noted that currently paygo and book reserve schemes do not fall under the requirements of the IORP Directive. One of the goals of the IORP Directive was to enable the creation of an effective single market, in particular in relation to investment management. Since these schemes have no external assets, it was not felt necessary for the IORP Directive to apply to them. However, it is not clear that simply by virtue of being unfunded such schemes should continue to be exempt from the Directive whereas schemes that are already backed by a degree of funding should fall within its scope. Page 9