Towers Watson has written to the European Commission suggesting how the Commission could design a system of pension funding rules that more closely resembles the Solvency II regime used for insurers but which does not significantly increase funding and compliance costs for employers with defined benefit liabilities.
The consultancy, which advises leading pension funds, employers and insurers throughout Europe, believes the Pensions Directive is likely to be reformed in one way or another and says the pensions industry should therefore focus on trying to ensure that proposed requirements will be workable rather than hoping that the whole idea will be dropped.
To that end, Towers Watson proposes a common framework within which pension schemes could assess their “solvency” position – i.e. the extent to which members’ benefits could be secured immediately without further recourse to the employer. Schemes would be required to disclose to national supervisors the extent to which such liabilities are covered by assets in the fund and the degree to which they rely on other security mechanisms for cover.
Towers Watson suggests that this would make the nature of the pensions promise more transparent and make the different pension systems in Europe more comparable, a key objective of the Commission. However, it would then be for national legislation and regulators to determine whether too much reliance was being placed on other features of the pension scheme instead of tangible assets and, if so, what should be done to correct that. National legislation could also specify the framework for setting any funding targets that must be met by tangible assets.
In the UK, the most important bridge between assets and liabilities on this “solvency” basis is the prospect of receiving further financial support from the sponsor (“the employer covenant”), though the Commission has said that recourse to the Pension Protection Fund can also be viewed as an intangible pension scheme asset. In some countries, the ability of pension schemes to cut benefits in stressed financial circumstances, which makes liabilities are less of a fixed target, will also be relevant.
The concept of a Holistic Balance Sheet (HBS), showing how all of these factors in combination are equal to a pension scheme’s solvency liabilities, is expected to be at the heart of any EU-wide system of pension funding rules. The letter from Mark Stewart, head of Retirement Solutions for Towers Watson in Europe, to Michel Barnier, the Internal Markets and Services Directorate General Commissioner, acknowledges that the HBS is a “potentially useful” idea that could “provide an objective representation of the solvency position” of pension schemes in very different environments.
However, the letter argues that placing precise values on the covenants of very different employers, pension protection vehicles and benefit reduction mechanisms in a consistent way “will be difficult and potentially controversial” and cautions against building a funding regime on the sort of “spuriously objective fudge” that could result when policymakers try to balance a regulatory regime’s requirement for precise numbers with an affordable way of estimating them. Instead, “what really matters” in order to protect pension scheme members is “the plan sponsor’s business model and its capacity for future wealth generation, backed by strong governance, risk management and supervisory oversight”.
The letter concludes that rescuing the potentially useful idea of the HBS from an “expensive quantification process” provides a practical way of ensuring that the security of the pension promise is transparent. It could also deliver the Commission’s objective of greater comparability across Europe without “provoking behaviours that could undermine the Europe 2020 agenda for growth” – the likely result if sponsors are forced to place a formulaic value on the employer covenant and then move quickly to make their schemes fully funded against more insurance-style liability measures under a standardised European timetable.
Mark Dowsey, a senior consultant at Towers Watson, said: “In the UK, solvency numbers are already calculated every three years as part of an actuarial valuation, and applying a common framework to this would not be too onerous. As now, a lower funding target that that takes account of the employer covenant could be used for budgeting purposes, with trustees justifying their reliance on the employer to the regulator as necessary.
“Even with this more flexible approach, it must be clear from the outset that any balance sheet featuring liability numbers calculated using insurance-style principles would be used for supervisory purposes only and would not feed through to the numbers on the sponsoring employer’s balance sheet.”