RING-FENCING IN STRESS SITUATIONS

CEIOPS-OP-08-09 Rev6 10 May 2010 RING-FENCING IN STRESS SITUATIONS Supplement to CEIOPS Conclusions of the Initial Review of Key Aspects of the Implementation of the IORP Directive 1/45

TABLE OF CONTENTS TABLE OF CONTENTS...2 EXECUTIVE SUMMARY...3 1.0 INTRODUCTION...6 1.1 Background... 6 1.2 Objective... 7 1.3 Limitations to the scope of the paper... 7 1.4 Definitions... 8 1.5 Legal Forms of IORPs... 10 1.6 Default Scenarios Considered... 15 1.7 Case Studies Considered... 18 2.0 STRESS SCENARIOS AND CASE STUDIES... 20 2.1 SCENARIO 1:... 20 2.2 SCENARIO 2:... 27 2.3 SCENARIO 3a:... 33 2.4 SCENARIO 3b:... 39 3.0 CONCLUSIONS... 41 APPENDIX 1 EXTRACT FROM THE RING FENCING REPORT JULY 2007... 42 2/45

EXECUTIVE SUMMARY Objective The objective of this paper is, in the context of cross border IORPs, to analyse the effectiveness of ring-fencing measures in protecting pension benefits in stress situations, in particular where such measures are imposed by a Home Member State Competent Authority, as envisaged by Article 16(3) 1 of the IORP Directive. In the course of this analysis, scenarios where pension benefits are at risk are presented. The paper does not offer solutions to adverse consequences of stress situations, since any such solutions lie beyond the remit of supervisors. The paper supplements the conclusions of the Key Implementations Report 2. Limitations to the scope of the paper This Paper does not attempt to be a comprehensive or a legal analysis of all of the issues arising when considering ring fencing. It merely attempts to highlight that possible implications exist. The outcomes in stress scenarios seem to depend very much on the type and structure of the IORP as well as the legal framework prevailing in a particular country, particularly in the areas of financial services, insolvency and bankruptcy, creditors rights and ownership rights. This is a very complex area to assess and analyse. It is recommended that should this area be pursued, it is also referred for legal analysis and verification of the actual extent of potential implications arising in this regard. The IORP Directive does not contain a definition of the term "ring-fencing". Whilst the remit of this paper is not to provide such a definition, nevertheless for the purpose of this paper a distinction is made between administrative ring-fencing and patrimony protection rules: Administrative ring-fencing separates the assets and liabilities of different pension schemes operated by the same IORP/Trustee only on paper, and is most commonly used for the calculation for scheme-specific setting of contribution levels, granting of indexation, etc. For the purpose of this paper, patrimony protection rules provide for a full legal and financial separation of assets and liabilities belonging to different pension schemes operated by the same IORP/Trustee. Patrimony protection rules assume administrative ring-fencing measures are in place. Stress Scenarios Considered The paper considers three default Scenarios, namely default of: [1] one of the pension schemes operated by an IORP; [2] the IORP itself; and [3] the service provider/iorp operator (as reflected in the Table 2 to this Paper). 1 Article 16(3) of the IORP Directive states that In the event of cross-border activity as referred to in Article 20, the technical provisions shall at all times be fully funded in respect of the total range of pension schemes operated. If these conditions are not met, the competent authorities of the Home Member State shall intervene in accordance with Article 14. To comply with this requirement the Home Member State may require ring-fencing of the assets and liabilities. 2 Initial review of key aspects of the implementation of the IORP Directive; CEIOPS-OP-03-08 (final); 31 March 2008. 3/45

The possible defaults have been considered by taking into account three different legal forms of IORPs, namely: [1] the institutional type; [2] the contractual type, and [3] trusts (as reflected in Table 1 to this Paper). Three Case Situations are analysed, as applicable 3, for each of the above default scenarios: Case 1: Administrative ring-fencing measures and Patrimony protection rules apply Case 2: Administrative ring-fencing measures but No patrimony protection rules apply Case 3: No Administrative ring-fencing measures and No Patrimony protection rules apply Main Conclusions The main conclusions from this paper are summarised hereunder: General The outcomes in stress scenarios seem to depend very much on the type and structure of the IORP. The myriad of different legal forms and structures of the IORP makes the analysis of possible implications quite complex. From the analysis of the default scenarios considered in this paper, Pension Schemes could be exposed to risks arising from stresses related: [i] to other pension schemes; or [ii] to non-occupational retirement provision activities 4 or entities, such as service providers. Further to the above, such risks could also have implications for cross-border pension provisioning. Administrative ring-fencing measures and Patrimony Protection Rules Administrative ring-fencing measures appear to play an important role in ensuring compliance with the fully funded requirement in terms of Article 16(3) of the IORP Directive in the case where an IORP is operating more than one Pension Scheme. Administrative ring-fencing measures in the Member State where the IORP is established but also where the service providers / operators of the IORP (in the instance these have custody or control over the IORP assets) appear to play an important role. Where legal certainty is not provided due to the absence of a Patrimony Protection framework, member benefits are exposed to risks; however, administrative ring-fencing measures may provide certain safeguards but may not necessarily be sufficiently comprehensive in certain scenarios. The type of administrative ring-fencing measures adopted then appears to be important for the protection of pension benefits, in combination with privilege rules where they exist. 3 In so far as Trust IORPs are concerned, given the particular Patrimony Protection Rules embedded in trust set-ups, only Case 1 applies for scenarios regarding trusts. 4 Subject to Art. 7 of the IORP Directive which states that institutions limit their activities to retirement-benefit related operations and activities arising therefrom; or in case of insurance undertakings (in accordance with Art. 4) the limitation is on the ring-fenced assets and liabilities. 4/45

A Patrimony Protection framework provides legal certainty in the protection of benefits within a Pension Scheme, in legally separating assets of a Pension Scheme from assets of any service provider or from assets of other Pension Schemes in a default scenario and limiting access thereto by creditors or beneficiaries not related to that Pension Scheme. The overall conclusion is that depending on the combination of the legal form of the IORP, the various stress situations directly or indirectly related to a pension scheme and different levels of protection offered by patrimony protection rules and administrative ring-fencing measures, the consequences for the protection of pension benefits are different. 5/45

1.0 INTRODUCTION 1.1 Background Directive 2003/41/EC of the European Parliament and of the Council on the activities and supervision of institutions for occupational retirement provision ( the IORP Directive ) contains various references to ring-fencing. Such articles are referred to in Recital 38 and Articles 3, 4, 7, 16(3), 18(7) and 21(5). Article 8 is also of relevance given that ring-fencing is often associated with some form of legal separation between sponsoring undertakings and IORPs. The above Articles refer to different forms and consequences of ring-fencing in specific contexts. This notwithstanding, the IORP Directive does not include a definition of ring-fencing or the techniques that should be applied in order to achieve the different forms and consequences of ring-fencing referred to in the IORP Directive in the contexts in question. In addition, the application of ring-fencing is not obligatory other than in the context of Articles 3 and 4 of this directive. A questionnaire on Ring-fencing in the area of IORPs was circulated to CEIOPS Members in 2008. One particular objective of this Ring-Fencing Questionnaire was to assess how ring-fenced assets are affected in the event of stress situations (i.e. problematic financial situations such as default, bankruptcy, insolvency and deficits) and determining the legal consequences arising in such circumstances. The following is a summary of the salient findings of this Questionnaire: ring-fencing is, to some extent, a subjective area given that: [i] countries can adopt different approaches to ring-fencing; and [ii] ring-fencing is an optional rather than an obligatory measure in particular scenarios; there are countries where ring-fencing is optional and in others where it is prohibited; there exist variances in the levels of protection afforded to ring-fenced assets amongst countries; and as a result, the safeguards expected from ring-fencing may in practice not work as expected in certain scenarios or in certain countries, thus potentially raising issues for cross-border pension provisioning (particularly in terms of Article 16(3) of the IORP Directive) should a stress scenario develop. The results of the Ring-Fencing Questionnaire were submitted to the European Commission in March 2008 5. An extract of the Report regarding the Legal Consequences of Ring-Fencing and the conclusions arising there from is attached as Appendix 1 to this Paper. 5 Section 4.2 and appendix 3 of the report: Initial review of key aspects of the implementation of the IORP Directive; CEIOPS-OP-03-08 (final); 31 March 2008. 6/45

1.2 Objective The objective of this paper is, in the context of cross border IORPs, to analyse the effectiveness of ring-fencing measures in protecting pension benefits in stress situations, in particular where such measures are imposed by a Home Member State Competent Authority, as envisaged by Article 16(3) 6 of the IORP Directive. In the course of this analysis, scenarios where pension benefits are at risk are presented. The paper does not offer solutions to adverse consequences of stress situations, since any such solutions lie beyond the remit of supervisors. The paper supplements the conclusions of the Key Implementations Report 7. 1.3 Limitations to the scope of the paper This Paper does not attempt to be a comprehensive or legal analysis of all of the issues arising when considering ring fencing. It merely tries to highlight that possible implications exist. The outcomes in stress scenarios seem to depend very much on the type and structure of the IORP as well as the legal framework prevailing in a particular country particularly in the areas of financial services, insolvency and bankruptcy, creditors rights and ownership rights. This is a very complex area to assess and analyse. It is recommended that should this area be pursued, it is also referred for legal analysis and verification of the actual extent of potential implications arising in this regard. The IORP Directive does not contain a definition of the term "ring-fencing". Whilst the remit of this paper is not to provide such a definition, nevertheless for the purpose of this paper a distinction is made between administrative ring-fencing and patrimony protection rules: Administrative ring-fencing separates the assets and liabilities of different pension schemes operated by the same IORP/Trustee only on paper, and is most commonly used for the calculation for scheme-specific setting of contribution levels, granting of indexation, etc. For the purpose of this paper, patrimony protection rules provide for a full legal and financial separation of assets and liabilities belonging to different pension schemes operated by the same IORP/Trustee. Patrimony protection rules assume administrative ring-fencing measures are in place. 6 Article 16(3) of the IORP Directive states that In the event of cross-border activity as referred to in Article 20, the technical provisions shall at all times be fully funded in respect of the total range of pension schemes operated. If these conditions are not met, the competent authorities of the Home Member State shall intervene in accordance with Article 14. To comply with this requirement the Home Member State may require ring-fencing of the assets and liabilities. 7 Initial review of key aspects of the implementation of the IORP Directive; CEIOPS-OP-03-08 (final); 31 March 2008 7/45

1.4 Definitions For the purposes of this Paper, the following terms are defined as follows: Default refers to a situation of insolvency or bankruptcy of an IOPR or another entity, as a result of which that IORP/entity is not in a position to meet its financial obligations and defaults on those obligations. This is different than a situation of under-funding (please refer to definition of Funding Problems in this regard). Default of the scheme refers to a situation where a pension scheme is underfunded and needs to be wound up i.e. the assets within the scheme are not sufficient to meet the liabilities and the sponsoring undertaking or the scheme (where this is providing any guarantees) is not in a position to meet its obligations to honour the benefits offered by the Scheme. Funding Problems refers to a situation of under-funding of a pension scheme i.e. a situation where the liabilities of a pension scheme exceed the assets of that pension scheme. Ring-Fencing (Measures) refers to (see also above - section 1.3: a. measures taken by an IORP operating a Pension Scheme, to strictly separate activities or assets and liabilities related to a Pension Scheme from: - its own assets 8 and liabilities and activities where applicable (e.g. IORP is an insurance undertaking), and / or - the assets and liabilities and activities related to other Pension Schemes also operated by that IORP (i.e. where IORP is operating more than one Pension Scheme); and / or b. measures taken by a service provider to strictly separate the assets and liabilities under its control on behalf of the IORP, from its own assets and liabilities and / or from the assets and liabilities related to other Pension Schemes also operated by that service provider. Ring-fencing measures can take various forms to achieve the required separation including for example: allocation rules to identify separate parts; the retention of separate accounting records for each Pension Scheme under the operation of the IORP, ensuring that all the liabilities and assets of each Pension Scheme operated by an IORP can be identified and traced with ease from each other and where applicable, also from the assets and liabilities of the IORP / operator itself; the maintenance of separate bank accounts, so as to prevent intermixing of funds between Pension Schemes operated by the same IORP / operator; separation of business areas with own management and administration 9. Administrative Ring-Fencing measures are ring-fencing measures of an administrative nature only, and the consequent separation achieved by such measures may not necessarily be recognised at law in stress scenarios, unlike Patrimony Protection rules. 8 Subject to Art. 7 of the IORP Directive which states that institutions limit their activities to retirementbenefit related operations and activities arising therefrom; or in case of insurance undertakings (in accordance with Art. 4) the limitation is on the ring-fenced assets and liabilities. 9 EFRP Legal Commentary re Directive 2003/41/EC on the activities and supervision of IORPs, October 2004; pages 9, 10 8/45

Patrimony Protection rules are legal provisions aimed at protecting the assets and liabilities held by an entity (e.g. IORP) on behalf of a client (e.g. Pension Scheme Members / Beneficiaries) from access thereto by the creditors of that entity or the creditors of other clients whose assets are also held by that entity. In particular, in this context of pension provisioning, Patrimony Protection rules are being defined to refer to a legal framework in terms of which: a. a Pension Scheme s assets held by or under the control of an IORP / operator 10, are considered as legally distinct and separate from the assets of that IORP / operator and from those of other Pension Schemes assets which are also under the control of the same IORP / operator, notwithstanding that the Pension Scheme assets may be registered in the name and title of or are otherwise vested in the IORP / operator. b. creditors of the IORP / operator, or of another Pension Scheme operated by the same IORP, have no claim or right of action on or against the assets held under the control of the IORP / operator for and on behalf of and in the interest of any Pension Scheme and such assets are not affected in any manner by the provisions of laws and regulations in force regulating the insolvency or bankruptcy of the IORP / operator in question. c. a Pension Scheme, whose assets are held under the control of the IORP or operator, enjoys a right of ownership in such assets notwithstanding that they may be registered in the name and title of the IORP / operator. Moreover, where such assets are held by the IORP / operator as part of a common pool of identical assets or are otherwise held in a clients or common account, the Pension Scheme shall have an undivided share in ownership of all the assets held collectively by that IORP / operator in such a pool or account. For the purposes of this paper, Patrimony Protection Rules are considered to be the legal framework providing legal recognition of the separation of the assets provided by administrative ring-fencing measures and the legal protection of those assets from access by third parties. Therefore, patrimony protection rules assume that administrative ring-fencing measures are in place. Pension Scheme(s) refers to the contract, agreement, trust deed or rules stipulating which retirement benefits are granted and under which conditions. It should be noted, that the trust scenario in the United Kingdom, where one trust deed and rules provides for segregated sections, pension schemes are generally treated as separate schemes including for funding and cross border purposes. This can be contrasted with the position under trust law in Ireland, where there is no segregation of schemes or arrangements within one trust. Use of the term scheme for the purpose of this document includes segregated schemes. Privilege Rules refers to the rules in the legal framework which determine whether beneficiaries of Pension Schemes enjoy priority on the IORP assets versus other creditors in the event of a default of the IORP. Beneficiaries are the individuals receiving a retirement benefit. 10 Reference to IORP or operator is intended to cater IORPs which have a legal personality as well as IORPs which do not have a legal personality but which are operated by an external service provider (e.g. Trustee or Pension Fund Managing Entity) Please refer to section 1.4 for further details. 9/45

1.5 Legal Forms of IORPs 1.5.1 The IORP Directive does not concern the legal form adopted by IORPs. IORPs can be established in different legal forms in different EU Member States depending on the national legislative framework adopted by the particular Member State. 1.5.2 However the legal form adopted by an IORP is a determinant factor in the establishment of the ownership of the assets of the pension scheme/s operated by that IORP. In turn, ownership of assets of a pension scheme could be an important factor in a stress scenario. Accordingly this section deals briefly with the different legal forms that have been adopted by IORPs in general. 1.5.3 In this regard, IORPs can generally be either of the institutional type or of the contractual type. An IORP can also be in the form of a Trust operated by a Trustee 11 : IORPs which fall within the institutional type are those which are independent entities with distinct legal personality and capacity, and which have their own internal governing boards (such as a corporate entity or pension foundations and associations with internal boards). The corporate entity or the foundation or association and hence their shareholders or members are the legal owners of the assets of the pension schemes under their operation. Members and beneficiaries of the pension scheme have a contractual claim against the IORP for the promised benefits. Service providers (such as asset managers and custodians) may be appointed by the Board of the IORP to carry out specific functions. Such service providers, where entrusted with the custody or control of assets of the pension schemes, would hold the assets on behalf of the IORP. The IORP may have its own assets other than the assets of the pension scheme/s under its operation (e.g. Article 4 of the IORP Directive refers to the possibility of IORPs being insurance undertakings). The contractual type of IORPs are a pool of assets without legal personality managed by an external governing body / dedicated service provider (e.g. pension fund management company or insurance undertaking) other than a Trustee or a Board of Trustees, tasked with operational responsibility of the pension scheme. Members and beneficiaries of the pension schemes have a contractual claim against the pension scheme assets under the management of the service provider tasked with operational responsibility of the pension scheme. The external governing body / dedicated service provider is legally responsible for the IORP. 11 Stewart, F. and J. Yermo (2008), "Pension Fund Governance: Challenges and Potential Solutions", OECD Working Papers on Insurance and Private Pensions, No. 18, OECD publishing, OECD. doi:10.1787/241402256531 10/45

The external governing body / dedicated service provider managing the pension scheme would hold the assets on behalf of the pension scheme members / beneficiaries. Any other service providers (such as a custodian) that may be appointed by the external governing body / dedicated service provider managing the pension scheme, would hold any pension scheme related assets on behalf of the IORP. A trust consists of a pool of assets without legal personality, under the administration of a Trustee or a Board of Trustees ( hereinafter referred to as Trustee ). The Trustee (an external governing body / dedicated service provider) must administer the trust property (i.e. the IORP property) in the sole interest of the scheme members and beneficiaries. A Trustee may act as a trustee for more than one IORP (trust). In a Trust set-up, the Trustee is the legal owner of the assets held by it on trust. Trustees are subject to the following particular and specific patrimony protection rules 12 : Assets held on trust legally constitute a fund separate from: [i] the personal trusts of the Trustee; and [ii] assets held on trust are separate from any other assets also held on trust by the same Trustee; personal creditors of the trustee shall have no recourse against the trust assets; the trust assets shall not form part of the trustee s estate upon his insolvency or bankruptcy; the trust assets shall not form part of the matrimonial property of the trustee or his spouse nor part of the trustee s estate upon his death; and the trust assets may be recovered when the trustee, in breach of trust, has mingled trust assets with his own property or has alienated trust assets. However, the rights and obligations of any third party holder of the assets shall remain subject to the law determined by the choice of law rules of the forum. The scheme members have a beneficial right to the proceeds arising from the pension scheme of which they are a member. Service providers (such as asset managers and custodians) may be appointed by the Trustee of the IORP to carry out specific functions. Such service providers, where entrusted with the custody or control of assets of the pension schemes, would hold the assets on behalf of the Trustee. 1.5.4 In summary: Neither IORPs in the form of trusts nor those of a contractual nature have legal personality. In addition, both are governed by external governing bodies / dedicated service providers in the case of Trust IORPs this would be the Trustee who would also have the legal 12 The Hague Convention on the law applicable to trusts and on their recognition, which was adopted by the Hague Conference on Private International Law on the 20 October 1984, and which came into force on the 1 January 1992 11/45

ownership of the Trust IORP s assets; whereas in the case of contractual IORPs, this would be the dedicated service provider who would only hold the IORP s assets on behalf of the IORP members and beneficiaries. IORPs which are trust based, as a result of the Hague Convention are legally automatically subject to particular Patrimony Protection Rules as described above under trusts. In the case of IORPs of the contractual or institutional type, Patrimony Protection Rules can only exist due to national legislation. Moreover, the trust (the IORP) represents in general one single pension scheme but may in limited circumstances represent two or more schemes, which are legally separated and the assets of which are legally separated. On the other hand, the institutional and contractual type IORPs may operate one or more pension scheme for one single or multiple employer/s. 12/45

Table 1 below outlines a description of the general features (including ownership of the assets) of IORPs of the institutional and contractual type and IORPs in the form of trusts. Table 1: IORPs of institutional and contractual type 13 and IORPs in the form of trust Type Legal Form Ownership of Pension Scheme Assets operated by the IORP Other Features Institutional Type Legal Personality Assets of the pension schemes are legally owned by the IORP and ultimately by the shareholders (if corporate) or members (in case of foundations / associations) thereof. Members and beneficiaries of the pension scheme have a contractual claim against the IORP for the promised benefits. Any appointed service providers would hold the assets on behalf of the IORP The IORP can be operating more than one Pension Scheme for different employers The IORP may have its own assets other than the assets of the pension schemes under its operation (e.g. Article 4 of the IORP Directive refers to the possibility of IORPs being insurance undertakings) There are Member states where the IORP cannot carry out any other activity apart from supplementary pension provision. Contractual Type No personality capacity legal or Managed by a dedicated Service Provider Members and beneficiaries have a contractual legal claim to the assets represented by the IORP The external governing body / dedicated service provider managing the contractual IORP would hold the IORP assets on behalf of the members and beneficiaries of the scheme The IORP can be representing more than one Pension Scheme for different employers The external governing body / dedicated service provider managing the contractual IORP may have its own assets other than those of the IORPs under its management Any service providers appointed by the external governing body / dedicated service provider would hold the IORP assets on behalf of the external governing body / dedicated service provider 13 http://www.oecd.org/dataoecd/23/12/2756201.pdf 13/45

Type Legal Form Ownership of Pension Scheme Assets operated by the IORP Other Features Trust No legal personality. Operated and Administered by a Trustee (i.e. an external service provider) Members and beneficiaries have a beneficial right to benefits arising from the trust assets The Trust IORP Assets are legally owned by the Trustee. Any service providers appointed by the Trustee would hold the IORP assets on behalf of the Trustee The Trustee may act in relation to more than one Trust (IORP) The IORP (trust) represents in general one single pension scheme but may in limited circumstances represent two pr more schemes but which are legally separate. The Trustee may have its own assets other than the assets of the pension schemes under its operation. Any assets owned by the Trustee in relation to any trust under its administration must be kept separate and distinct from each other and from the Trustee s personal assets. 14/45

1.6 Default Scenarios Considered 1.6.1 The IORP Directive implies that an IORP can be responsible for more than one pension scheme (Article 11 of the IORP Directive). It also appears that the IORP can either itself cover certain biometric risks or these can be covered by the sponsoring undertaking (Article 17 of the IORP Directive). Therefore, in terms of these articles, it is assumed that it is possible to have the following pension scheme / IORP set-ups 14 : a. One IORP managing one pension scheme for one single sponsoring undertaking (i.e. one scheme for one single employer). b. One IORP managing one pension scheme (having standard features / guarantees) to different sponsoring undertakings that have a business relationship between them (i.e. one scheme for connected multiple employers). c. One IORP managing different pension schemes, with each pension scheme having different features sponsored by different unconnected sponsoring undertakings (i.e. multiple schemes for unconnected multiple employers). 1.6.2 It is considered that only set-up (c) mentioned in paragraph 1.6.1 above (i.e. where the IORP is managing more than one different pension scheme possibly for different unconnected sponsors) is relevant for purposes of assessing implications of stress scenarios. This is considered to be the case since only in this set-up, a default of one of the pension schemes (sponsored by a particular or related sponsoring undertaking/s or which itself is offering certain guarantees) or default of the IORP (where this has legal personality and has its own assets) can affect other unrelated pension schemes which are also under the operation of the same IORP. 1.6.3 It is also considered that pure defined contribution schemes cannot default, as their liabilities towards their members are in principle equal to the assets they hold on behalf of these members. Therefore, with regard to a default of a Pension Scheme, only pension schemes which provide a guaranteed benefit are taken into account, which inter alia include defined benefit schemes and schemes of a defined contribution nature which offer some kind of guarantee to their members (e.g. a guaranteed minimum investment return). This notwithstanding, defined contribution schemes can be influenced by a default of their IORP / operator or of a service provider appointed by their IORP / operator. For the purpose of this paper, the term "pension scheme" is considered to refer only to pension schemes which provide a guaranteed benefit. Moreover, in certain countries, it is possible for pension schemes experiencing underfunding situations to cut down on accrued benefits. For purposes of this paper, when considering underfunding / default scenarios of schemes, it is assumed that despite the adoption of such measures, the situation has deteriorated such that it still leads to default. 14 It is not excluded that set-ups other than those identified in 1.6.1 are possible in different EU Member States. However only the set-ups identified in paragraph 1.6.1 have been taken into account in identifying the possible default / stress scenarios for purposes of this paper. 15/45

1.6.4 In this regard, further to Section 1.5 and paragraphs 1.6.1 and 1.6.2 above: The default scenarios related to the institutional type of IORP regard situations where there is default of: o one of the pension schemes, that is being managed by the IORP; o the IORP where the IORP (e.g. insurance undertaking) also has its own assets apart from the assets of the pension schemes under its operation / control 15 ; o any service provider appointed by the IORP. Moreover, that service provider may also have its own assets apart from the assets of the pension schemes under its control on behalf of the IORP. The default scenarios in the case of a contractual type of IORP regard situations where there is default of: o one of the pension schemes being managed in the name of the contractual IORP by the external governing body / dedicated service provider; o the external governing body / service provider responsible for the operation of the IORP. This body may also have its own assets apart from the assets of the pensions schemes under its control on behalf of the IORP; o a service provider (e.g. Asset Manager / Custodian) which had been appointed by the external governing body / dedicated service provider. Such service provider may also have its own assets apart from the assets of the pension schemes under its control on behalf of the external governing body / dedicated service provider responsible for the IORP. The default scenarios in the case of Trust IORPs regard situations where there is default of: o the sponsor and / or one of the pension schemes operated by the Trustee, in those circumstances where the IORP Trust contains more than one pension scheme and the assets of that pension scheme are insufficient to meet the liabilities for that scheme; o the Trustee; o a service provider (e.g. Asset Manager / Custodian) that may have been appointed by the Trustee. That service provider may have its own assets apart from the assets under its control on behalf of the Trustee. 1.6.5 The possible stress scenarios taking into account the different legal forms which may be adopted by an IORP are outlined in Table 2 below. 15 Subject to Art. 7 of the IORP Directive which states that institutions limit their activities to retirement-benefit related operations and activities arising therefrom; or in case of insurance undertakings (in accordance with Art. 4) the limitation is on the ring-fenced assets and liabilities. 16/45

Table 2: Possible Stress Scenarios, taking into account the different legal forms which may be adopted by an IORP Legal Form of the IORP Pension Scheme Possible Stress Scenarios IORP Service Providers Institutional Type {A} Default of one of the Pension Schemes being operated by the IORP [B} Default of the IORP {C} Default of Service Provider who is holding the assets of the pension schemes operated by the IORP on behalf of the IORP (e.g. Depositary or Administrator or Management Company) Contractual Type {D} Default of one of the pension schemes being managed in the name of the contractual IORP by the external governing body / dedicated service provider {E} Default of the external governing body / dedicated service provider who is managing the IORP and who is holding the assets of the pension schemes under that IORP {F} Default of a Service Provider (e.g. Depositary or Administrator or Management Company) who is holding the assets of the IORP on behalf of the IORP s external governing body Trusts {G} Default of one of the pension schemes being managed in the name of the Trust IORP by Trustee {H} Default of the Trustee who is the legal owner of the assets and who is operating the IORP and which may have its own assets {I} Default of Service Provider (e.g. Depositary or Administrator or Management Company) who is holding the assets of the pension schemes operated by the IORP on behalf of the Trustee 1.6.6 Accordingly the paper considers the following possible Stress Scenarios (as reflected in Table 2 and also taking into account the possible action taken by a Home State Regulator in terms of Article 14 of the IORP Directive): Scenario 1 - Default of a Pension Scheme where the IORP is of an institutional type or the IORP is a Trust / Contractual in nature: Underfunding and eventual default of the Pension Schemes being operated by an IORP. In this scenario the IORP has legal personality [Table 2 Default Scenario A], or the IORP is contractual in nature [Table 2 Default Scenario D] or is a trust [Table 2 Default Scenario G]. In this scenario, the default by the Pension Scheme is taken to occur in a period of temporary underfunding. In this regard to note that Article 16(3) stipulates that in a cross-border scenario, all Pension Schemes operated by the same IORP shall be operated on a fully funded basis at all times. In the instance that the IORP complies with this requirement then the scenario of default of any scheme operated by that IORP should not arise. However, despite the fully funded requirement, there could still be a situation of 17/45

temporary underfunding i.e. a time gap between the determination of a situation of underfunding and the rectification of that situation. This scenario aims to address the question as to what will happen to beneficiaries of Pension Schemes, should a Pension Scheme also operated by the same IORP, defaults during a period of under-funding. In this regard it is being assumed that the sponsoring undertaking is not in a position to cover the deficit or the IORP cannot itself raise funding and the IORP has no other options to recover from the situation of underfunding. To also note that in terms of Article 16(3), the Competent Authority of the IORP s Member State may intervene in accordance with Article 14 in the event of underfunding. Such action may include the restriction or prohibition of disposal of the IORP s assets. Scenario 2 - Default of an IORP which has legal personality: Default of the IORP, where the IORP such as an insurance undertaking, has legal personality [Table 2 Default Scenario B]. Scenario 3a - Default of the External Service Provider of an IORP: Default of the external governing body / dedicated service provider of an IORP of a contractual nature [Table 2 Default Scenario E]. Default of Service Provider (e.g. Depositary or Administrator or Management Company) which: is holding the assets of the pension schemes operated by the IORP on behalf of the IORP (where the IORP has legal personality [Table 2 Default Scenario C] or on behalf of the external governing body / dedicated service provider where the IORP is of a contractual nature [Table 2 Default Scenario F]; or is holding the assets on behalf of a Trustee [Table 2 Default Scenario I]. Scenario 3b - Default of the Trustee: Default of the Trustee: (i) who is the legal owner of the assets; (ii) who is operating the Pension Scheme Trust; and (iii) which itself may have its own assets [Table 2 Default Scenario H]. 1.7 Case Studies Considered 1.7.1 The following Case Situations are taken into account, as applicable 16, for each Scenario: Case 1: Case 2: Administrative ring-fencing measures and Patrimony Protection Rules apply Administrative ring-fencing measures but No Patrimony Protection Rules apply 16 In so far as Trust IORPs are concerned, given the particular Patrimony Protection Rules embedded in trust set-ups, only Case 1 applies for scenarios regarding trusts. 18/45

Case 3: No Administrative ring-fencing measures and No Patrimony Protection Rules apply 1.7.2 Since the scope of this paper is the analysis of ring-fencing in stresssituations, the scenario where No Administrative ring-fencing measures apply but Patrimony Protection Rules prevail will not be considered (please refer to section 1.4). 1.7.3 It is important to note that the default scenarios under consideration will not necessarily be relevant or applicable to all Member States. The applicability or otherwise of each scenario for a Member State will depend on the possible legal forms that an IORP may take in that Member State and the different types of set-ups that may be assumed for pension schemes in a Member State. 19/45

2.0 STRESS SCENARIOS AND CASE STUDIES 2.1 SCENARIO 1: Default of a Pension Scheme where the IORP has legal personality (A Table 2), or the IORP is contractual in nature (D- Table 2) or is a trust (G - Table 2) Pension Scheme 1 in Member State 1 NOT FULLY FUNDED - DEFAULTS Pension Scheme 2 Member State 2 Pension Scheme 3 Member State 3 IORP Member State 3 This scenario considers the case where the IORP, operating on a cross-border basis, has insufficient assets to cover the technical provisions in respect of the total range of pension schemes operated. As a result the Competent Authority of the Home Member State restricts or prohibits the free disposal of the IORP s assets. Moreover, the eventual default of Pension Scheme 1 is also considered. 2.1.1 Case 1: Administrative ring-fencing measures and Patrimony Protection rules apply in Member State 3 This scenario is represented in Diagram 1. Diagram 1 - Assets held by the IORP: of Pension Scheme 1 NOT FULLY FUNDED / DEFAULTS of Pension Scheme 2 Assets of Pension Schemes should be identifiable and separate due to the administrative ring-fencing measures. Creditors of Pension Schemes 1 only have access to Assets of Pension Scheme 1 due to the patrimony protection rules. of Pension Scheme 3 20/45

The outer green box represents all the assets held by the IORP of all the Pension Schemes under the operation of the IORP. Each inside box represents the fact that the assets of each Pension Scheme held by the IORP are: o administratively ring-fenced (i.e. the assets of each Pension Scheme are separately identifiable and accounted for); and o subject to patrimony protection rules (i.e. the assets of each Pension Scheme are considered as legally separate and distinct from each other and legally protected from access by third parties). Pension Scheme 1 not fully funded Where a Pension Scheme is not fully funded, any underfunding will be easily and directly attributable to a specific Pension Scheme given the administrative ringfencing of Pension Scheme Assets. In this regard, it is presumed the Competent Authority of the Home Member State will only restrict or prohibit the free disposal of the assets of the underfunded Pension Scheme operated by the IORP (i.e. Pension Scheme 1) given the administrative ring-fencing measures and the patrimony protection rules which ensure that the assets of the Pension Schemes are considered as being legally separate and distinct from each other. Accordingly it is assumed that there would not be any restriction on the assets related to Pension Schemes 2 and 3, which should be able to continue to operate unaffected. However as the Competent Authority in question may make another decision regarding the restriction/prohibition of the free disposal of assets, the above results depend on the approach taken by that Competent Authority. Default of Pension Scheme 1 In the case of default of Pension Scheme 1 (i.e. the assets within the scheme are not sufficient to meet the liabilities and the sponsoring undertaking or the scheme (where itself offers guaranteed benefits) is not in a position to meet its obligations to honour the benefits offered by the Scheme), the Patrimony Protection rules in this scenario would provide the legal certainty that: the assets of the non-defaulting Pension Schemes would be considered distinct and separate from the assets of the defaulting Pension Scheme, and from the assets of each Pension Scheme operated by that IORP. This ensures that the assets of the defaulting Pension Scheme are easily identified; the creditors of the defaulting Pension Schemes would only have a legal claim on any assets belonging to the defaulting Pension Scheme and would not have any right of recourse against the assets of non-defaulting Pension Schemes; and the assets of non defaulting Pension Schemes would not form part of the assets of the defaulting Pension Scheme. Moreover, given the administrative ring-fencing measures, it should be possible to determine outright which are the assets of Pension Scheme 1, against which creditors of Pension Scheme 1 might have a claim. Accordingly the Patrimony Protection rules should be easily enforceable given that it would be legally clear which are the identifiable assets of Pension Schemes 1, 2 and 3. In this regard, there should not be any reduction in benefits payable by Pension Schemes 2 and 3 to beneficiaries for reasons related to the default of Pension Scheme 1 also operated by the same IORP. 21/45

Pension Scheme established as a Trust In a trust set-up where it is possible to have legally separate schemes within the same trust, for example a Defined Benefit and a Defined Contribution Scheme 17, this scenario is possible. However each Pension Scheme will be legally separated within the trust given the particular features of trust set-ups (section 1.5 refers), so patrimony protection rules (including administrative ring-fencing measures) apply automatically. In an underfunded scenario, the application of administrative ring-fencing measures could make it possible for Competent Authorities to apply a restriction / prohibition regarding the disposal of assets limited to the assets of the underfunded pension scheme. However, any application depends on the national legislation on ring-fencing and, as the Competent Authority in question may make another decision regarding the restriction/prohibition of the disposal of assets, the results depend on the approach taken by the Competent Authority in question. The administrative ring-fencing measures contribute towards easier and quicker application of Patrimony Protection rules in a default scenario, as the assets of Pension Schemes operated by the same IORP should be clearly identifiable and legally safeguarded where one of the Pension Schemes defaults. There should be no reduction in benefits payable by the respective Pension Schemes to their beneficiaries for reasons not related to the pension scheme itself. 17 It should be noted that not in all countries which provide a legal framework for trusts it is possible to have legally separate schemes within the same trust. 22/45

2.1.2 Case 2: Administrative ring-fencing measures but No Patrimony Protection rules apply in Member State 3 This scenario is represented in diagram 2. Diagram 2 - Assets held by the IORP: of Pension Scheme 1 NOT FULLY FUNDED / DEFAULTS of Pension Scheme 2 Assets of Pension Scheme 1 are easily identifiable due to administrative ringfencing measures. Creditors of Pension Scheme 1 could have access to Assets of Pension Schemes 2 and 3 due to the lack of patrimony protection rules. of Pension Scheme 3 The outer green box represents all the assets held by the IORP of all the Pension Schemes under the operation of the IORP. The lines cutting across the green box represent the separation of the assets of each Pension Scheme provided by the administrative ring-fencing measures applied by the IORP. Due to these measures, the assets and liabilities of Pension Scheme 1 are easily identifiable from those of Pension Schemes 2 and 3 respectively. No Patrimony Protection Rules apply (i.e. the assets of each Pension Scheme held by the IORP are not legally considered as separate and distinct from each other and are not legally protected from access by third parties). Pension Scheme 1 not fully funded In the instance where Pension Scheme 1 is not fully funded, assets are easily identifiable due to administrative ring-fencing measures in-force. In this regard, the Competent Authority of the Home Member State may decide to restrict or prohibit the free disposal of the IORP s assets in accordance with Articles 14 and 16 of the IORP Directive in relation to a. the assets of the underfunded Pension Scheme 1 only given the administrative ring-fencing measures even though no patrimony protection rules apply. In this regard, Pension Schemes 2 and 3 should be able to continue to operate unaffected for the time being. b. all the assets of all Pension Schemes 1 to 3 in view of the lack of Patrimony Protection rules. In this regard, then all the beneficiaries of the three Pension Schemes would be affected despite that Pension Schemes 2 & 3 may be operating on a fully funded basis. 23/45

Default of Pension Scheme 1 In the case of default of Pension Scheme 1, due to lack of patrimony protection rules, there is no legal framework which provides legal certainty that: the assets of Pension Schemes 1 to 3 are considered distinct and separate from the assets of each Pension Scheme operated by that IORP; the creditors of Pension Scheme 1 would not have right of recourse against the assets of the non-defaulting Pension Schemes; and the assets of the non-defaulting Pension Schemes would not be used to cover the deficit of the defaulting Pension Scheme upon its insolvency. Notwithstanding the lack of legal protection offered by Patrimony Protection Rules, the benefits payable under Pension Schemes 2 and 3 may still be safeguarded due to availability of clear attribution of assets between Pensions Schemes offered by the administrative ring-fencing measures. The safety provided by the administrative ring-fencing measures would also be dependent on the privilege rules that may prevail in the legal framework where the IORP is situated, which determine whether beneficiaries of Pension Schemes enjoy priority on the IORP assets in the event of a winding-up of the IORP. Pension Scheme established as a Trust This case does not apply to trust based systems since via the trust, the pension schemes will be legally separated through patrimony protection rules (including administrative ring-fencing measures) given the particular features of trust set-ups (section 1.5 refers). Where legal certainty in the protection of pension benefits is not provided due to the absence of a Patrimony Protection framework member benefits are exposed to risks. However, administrative ring-fencing measures in combination with for instance privilege rules may offer a degree of protection. 24/45

2.1.3 Case 3: No Administrative ring-fencing measures and No Patrimony Protection rules apply in Member State 3 This scenario is represented in diagram 3. Diagram 3 - Assets held by the IORP: of Pension Scheme 1 NOT FULLY FUNDED / DEFAULTS of Pension Scheme 2 Assets of the Pension Schemes are not easily identifiable due to the lack of administrative ring-fencing measures. Creditors of Pension Scheme 1 may have access to the assets of all Pension Schemes. of Pension Scheme 3 The outer green box represents all the assets held by the IORP of all the Pension Schemes under the operation of the IORP. There is no separation administrative or legally of the assets of each Pension Scheme: o No administrative ring-fencing of the assets of each Pension Scheme exists (i.e. the assets of each Pension Scheme are not necessarily separately identifiable and accounted for); and o No Patrimony Protection Rules apply (i.e. the assets of each Pension Scheme are not legally considered as separate and distinct from each other and are not legally protected from access by third parties). Pension Scheme 1 not fully funded In the case where Pension Scheme 1 is not fully funded, it may probably be the case that a possible restriction or prohibition of the free disposal of the IORP s assets by the Competent Authority is applied with respect to all the assets of all Pension Schemes operated by the IORP in view of the absence of administrative ringfencing and patrimony protection rules. In such a situation, Pension Schemes 2 and 3 would not be able to continue to operate unaffected despite the fact that the underfunding resulted from Pension Scheme 1. Default of Pension Scheme 1 In the case of default of Pension Scheme 1, due to lack of Patrimony Protection rules, there is no legal framework which provides the legal certainty that: the assets of Pension Schemes 1 to 3 are considered distinct and separate from each other; the creditors of Pension Scheme 1, in case of default, would not have right of recourse against the assets of the non defaulting Pension Schemes; and the assets of the non-defaulting Pension Schemes would not be used to cover the deficit of the defaulting Pension Scheme upon its insolvency. 25/45