Raise your buffers

Stringent solvency requirements for pension providers are currently benched and in need of overhauling, a risklab study suggests

The pension industry breathed a collective sigh of relief in May as European regulators dropped a bid to apply higher capital requirements to pension funds. Michel Barnier, the European commissioner for internal markets and services, postponed the implementation of pillar one of the revised Institutions for Occupational Retirement Provisions (IORPs) directive, stating that the Commission needs time to collect more data.

Capital rules, known as Solvency II, require insurance companies to put aside more capital to withstand future financial crises. The rules aim to make insurers safer by obliging them to hold capital reserves in proportion to the risk they take. Taking industry concerns about disparate regulatory premises for insurers and IORPs into account, European regulators were planning on applying the same capital rules to funded pension schemes.

MAKING LIFE HARDER

The proposal leaves many experts worried, including the authors of the risklab study Long-term Pension Investment Strategies under Risk-based Regulation. “The amount of capital a pension fund needs as a buffer to pursue even a moderate, much less an aggressive investment strategy, would balloon,” says Christian Schmitt, one of the study’s authors.

The whole pension plan would become a very expensive endeavor for the corporate sponsorChristian Schmitt

The new requirements would lead to a substantial increase in the value of liabilities that need to be covered by a higher amount of assets to bolster any risk of asset fluctuation or solvency capital requirements (SCR). The proposed regulation’s incentive would be to invest in a liability-matching portfolio, in which assets have a comparable maturity to liabilities, which would in turn act to reduce risk capital requirements. In their current format, the Solvency II-like quantitative requirements would make life harder for the pension fund chief investment officer. “They would significantly limit the range of investment strategies a portfolio manager can pursue,” says Schmitt.

The study carried out by risklab, a quantitative capital-market research firm owned by Allianz Global Investors, assessed the potential impact of the proposed requirements on long-term investment behavior. The researchers tasked themselves with looking at the regulation’s effect on the liability valuation and risk-based funding requirement of a fictitious pension fund. The fund was assumed to have both a generic pension plan and asset allocation.

Within the scope of the proposed holistic balance sheet approach (an attempt to also value other security mechanisms, such as the sponsor covenant as assets), it examined the effect on typical occupational pension plans and on various asset classes. The study takes three typical portfolios for European occupational pension funds: a conservative portfolio, a moderate one and an aggressive one. In all cases, the portfolios were found to be heavily under-funded under the proposed requirements.

RISK OF HERDING BEHAVIOR

Certain asset classes would be hit harder than others, the study shows. Government bonds, infrastructure, private equity and emerging market bonds would become more attractive to pension funds. Others, namely alternative assets, hedge funds or commodities, less so. The research suggests that long maturing government bonds would bring the least risk if you were to invest in just one asset class, says co-author Gerhard Scheuenstuhl.

While market effects were outside of the study’s scope, big pension funds buying into the more attractive asset classes are likely to push up their prices and thus distort the market, adds Scheuenstuhl. “As prudent investors would put together their investment to favor, for example, private equity over commodities, the regulation promotes a less than ideal portfolio composition.”

According to the risklab findings, the proposed changes would be a heavy burden on the pension funds and possibly also for corporate sponsors, who would be forced to set aside a risk buffer which – in today’s typical asset portfolios – could reach more than 50 cents for every euro invested. Sponsors unable to afford such a strong safety net might be pushed into safer portfolios at the cost of lower expected returns, which further increases their funding gap over time.

NEGATIVE IMPACTS

“The whole pension plan would become a very expensive endeavor for the corporate sponsor and many would want to quit as soon as possible,” Schmitt says. Some might even experience negative side effects on their operational businesses. To ease the burden, many corporate sponsors are likely to move from defined benefit (DB) to defined contribution (DC) plans, hastening the general trend towards DC.

Retirees couldn’t fully relax either. “With corporate sponsors financially overstretched by regulation, pension benefits may be lower in the long run,” adds Scheuenstuhl. “If a company were to go bankrupt, it would default on pension contributions and benefits provided by the pension protection fund may be far less generous.” Governments, meanwhile, could console themselves with the thought that the new requirements make current pension systems safer and provide a consistent regulatory framework throughout Europe. In the long run, governments might also suffer as the financial burdens added to employees under DC systems created welfare problems.

Ultimately, there is concern that solvency rules could stifle rather than encourage true long-term investment from all sides. The proposals could cost the industry in total, thwarting their ability to invest. Rethinking the IORPs directive seems a wise step on the way to regulation that provides a truly level playing field to all pension players.

Download the fully study from

Raise your buffers

Stringent solvency requirements for pension providers are currently benched and in need of overhauling, a risklab study suggests

Raise your buffers

Stringent solvency requirements for pension providers are currently benched and in need of overhauling, a risklab study suggests

Buy in or buy out? How to hedge longevity risk

Solvency who?

Is Solvency II suitable for IORPs?

Into thin air