Solvency II and what it means for defined benefit schemes

More European legislation on the horizon?Solvency II and what it means for defined benefitschemesWhat is Solvency II?The Solvency II Directive 2009 is a European Union directive that codifies and harmonises theEU insurance regulation. Primarily this concerns the amount of capital that EU Insurancecompanies must hold to reduce the risk of insolvency. Solvency II is scheduled to come intoeffect on 1 January 2014.Solvency II will directly affect annuities provided by insurers, likely increasing the cost of buyoutsand buy-ins.Separately, the EU has taken Solvency II and tried to apply similar rules to occupationalpension schemes. The EU has been seeking technical advice from the European Insuranceand Occupational Pensions Authority (EIOPA) who in turn have been seeking views frominterested parties by way of a consultation.What it could mean for pensionsFunding of the UK’s defined benefit (DB) pension schemes has traditionally involved anelement of flexibility. Company contributions are determined following triennial fundingvaluations. Where there are shortfalls the sponsoring employer and trustees agree recoveryplans over a number of years. Accordingly, schemes are, at many points in the cycle,underfunded with trustees and employers taking a long term view.If Solvency II were to apply to UK DB pensions, there would be a substantial increase in theassessed liabilities of pension schemes. In addition, a capital reserve buffer would be neededto ensure that the scheme remains fully funded under a variety of scenarios. Investment inmore volatile assets such as equities would require higher capital reserves.The cost of funding UK schemes to the standards proposed by the EU has been put at up to£600bn. Pension schemes would likely reduce their exposure to equities because of the higherreserves they would be expected to hold against volatile investments. This, in turn, wouldreduce future expected returns.At a time when the UKGovernment is seekingto reinvigorateoccupational pensions,further regulatoryproposals from Europethreaten to imposedraconian requirementsupon defined benefitschemes - if introducedas currently envisaged.Opponents of the plan to apply Solvency II to pensions suggest the ideais fundamentally flawed as occupational pensions have the benefit of asponsor’s support that is absent in the case of insurance companies.EIOPA’s consultation also suggests pension schemes should provide aquantitative measure of the strength of their employer covenant. This issomething which is extremely hard to measure.If implemented without consideration of the UK pensions environment, itwill inevitably lead to an increase in the rate of closure of DB Schemes.

More European legislation on the horizon?What is likely to happen?A good deal of uncertainty still surrounds the proposal to apply Solvency II to UK pensions.The EU has indicated that the proposals could at least be watered down. Whilst the whitepaper on pensions produced by the EC suggests it will continue to work on legislation for thepensions industry (IORP) it has said that this does not necessarily mean pensions will besubject to the exact same rules as Solvency II. The EU has said Solvency II has caused themto look at pensions but it does not mean they will copy it.The current EU proposals relieve DB pension funds from the need to provide a capital reservebuffer. Instead a “holistic balance sheet” approach is proposed. EIOPA favours allowingsponsor covenants and Pension Protection Fund guarantees to be taken into account in theholistic balance sheet approach. A press release says this will “enable IORPs to take intoaccount the various adjustment mechanisms (conditional indexation, reduction of accruedrights) and security mechanisms (regulatory own funds, sponsor support, pension protectionfund) in an explicit way.”The full details of this holistic balance sheet approach are still open to discussion and yet to befully finalised.The new proposals have done little to stem the flow of criticism for the wholeidea and political pressure could still result in the proposals being shelved orat least further amended before they are implemented.Find out moreIf you would like to discuss the content of this briefing note and how it will impact yourorganisation, please contact:Gary Crockford, Techical Services Manager.+44 (0)20 7429 1274 or gary.crockford@buckconsultants.comInformation contained in this briefing note is of a general nature only; it represents our understanding of current (andproposed) law and practice but should not be relied upon as advice in any specific situation.© 2012 Buck Consultants Limited. All rights reserved2