EU rule changes could force firms to pay off pension deficits more quickly

New proposals to create a harmonised funding regime for pension schemes throughout the European Union could force UK employers to pay off deficits more quickly, according to Towers Watson.

The European Commission has told the European Insurance and Occupational Pensions Authority (EIOPA) that it wants a revised Pensions Directive to require “consistent” recovery periods across all Member States. This might shorten permitted recovery plan lengths in the UK to bring them into line with those seen in other countries where companies have smaller defined benefit pension liabilities. If so, the Commission would need to consider what should happen where diverting more cash to the pension fund would threaten the future of the employer’s business.

The Commission has formally asked EIOPA to provide advice by December 2011 to inform a review of the Directive which governs pension scheme funding. Its Call for Advice discusses how defined benefit pension liabilities should be measured and how deficits should be repaid.

The Commission says its “aim is to attain a level of harmonisation where EU legislation does not need additional requirements at the national level”. As such, it intends to supplement a revised Pensions Directive with EU-wide “implementing measures” at a later stage (paragraph 7.1) rather than leaving these to Member States. The Commission says the “main purpose” of the Pensions Directive is to enable an employer in one Member State to sponsor a pension scheme based elsewhere (paragraph 3.1), and appears to regard the fact that there are currently fewer than 80 pension schemes operating across borders as a failure of the Single Market (paragraph 1.2).

John Ball, head of UK pensions at Towers Watson, said: “When the Directive was introduced in 2003, it was left to national governments to translate its requirements into law. The Commission’s main objection to the way they did this seems to be that different countries adopted different rules rather than that employees’ benefits are not adequately protected.

“The Commission thinks national differences are depriving employers of the right to operate pension schemes that cross borders. However, most employers will be more concerned about how harmonised rules might affect their responsibilities in respect of pensions they have already promised to employees in a particular country. It has been estimated that 61% of the defined benefit pension liabilities covered by the Directive are in the UK and 24% are in the Netherlands, so a common set of rules will primarily affect employers with DB liabilities in these two countries.”

How will pension liabilities be measured?

The Commission says that “pension schemes and pension products containing similar risks should be subject to similar regulatory requirements”, and that scheme funding rules should “to the extent necessary and possible, be compatible with” the Solvency II regime that will be applied to life insurers from 2013 (paragraph 4.4). However, it recognises that the covenant of the employer standing behind the pension liabilities and the existence of the Pension Protection Fund are “risk-mitigating” features which can reduce the amount of capital that pension schemes must hold (paragraph 4.5). It adds that “it should be possible to restate the value of assets in the [pension fund] and the liabilities of the sponsoring undertaking into a single balance sheet, including the possibility to recognise sponsor covenants and claims in pension protection schemes as an asset similar to reinsurance” (paragraph 4.3).

John Ball said: “Simply applying insurance funding rules to defined benefit pensions would have increased UK schemes’ funding targets by about 50%. Talk that this was about to happen always looked like scaremongering. Solvency II is the Commission’s starting point when thinking about pensions and a lot of the concepts have been carried across, but there are important modifications.

“The Commission’s position may well change the way that funding targets are calculated but it’s too early to conclude that it will make them more prudent overall; the Pensions Regulator already says a funding target below the level of resources needed to provide benefits without taking any risk must be justified by the employer’s ability to put things right if necessary. A lot will depend on any guidelines about how to put a value on the employer covenant.”

And how soon must deficits be repaired?

The Commission says that, where assets do not cover the resulting measure of liabilities, pension schemes “should set up concrete and realisable recovery plans. The recovery periods should be consistent across Member States and prudentially sound” (paragraph 4.5). In the Annex to its Call for Advice, the Commission asks EIOPA to pay “particular attention” to “the length of the recovery period allowed” when recommending rules for pension schemes (paragraph 6.4). The Solvency II Directive which it wants to draw on when devising rules for pension funds empowers the Commission to specify a maximum number of months within which shortfalls against insurance capital requirements must be rectified following an exceptional fall in financial markets (Article 143).

A fully harmonised regime for deficit recovery periods would involve changes to at least two of the three approaches currently used in Europe:

  • The Pensions Directive already requires schemes that carry out cross-border activity to be fully funded at all times. The Commission has asked EIOPA to look at whether “a specific wording for cross border activity” is still needed or whether they should be subject to the same rules as domestic pension plans (Annex, paragraph 6.4).
  • Several countries currently impose maximum recovery periods – in some cases of three years or less.
  • Others, like the UK, do not impose a maximum recovery period. The UK Pensions Regulator expects deficits to be paid off as quickly as reasonably affordable; recovery plans over 10 years attract greater scrutiny but longer periods are permitted. The regulator has said that the average recovery period agreed between employers and trustees for UK schemes with valuation dates between September 2008 and September 2009 was 9.4 years.

Mr Ball said: “If there is a big deficit and not much money available, something has to give. If the recovery plan cannot take the strain, what will? In some countries, the solution can include cutting the benefits the scheme must pay out but solvent UK employers are not allowed to do this and forcing a company into insolvency will seldom be in anyone’s interests.” 

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