Rowan Harris contributed to the writing of this blog post
Undaunted by budget cuts and lack of interest from stakeholders and the European Commission (EC), the European Insurance and Occupational Pensions Authority (EIOPA) has powered ahead with its pet project – further work on pension scheme funding and solvency.
Part of EIOPA’s remit is to monitor the European pensions and insurance sectors, and identify risks and vulnerabilities. Its latest bi-annual report on financial stability notes that pension funds have been hit hard by low yields, in part due to quantitative easing, and fears that defined benefit (DB) schemes may seek to increase risk in order to return to profitability. Further, EIOPA warns that low returns will reduce the income members can expect to receive from defined contribution (DC) schemes, which could be expected to impact on the economy by lowering demand.
Against this background, EIOPA has launched a stress test to determine how sensitive pension schemes are to changes in market conditions and longevity, and how this might impact on the stability of the financial sector.
The stress test for DC schemes will investigate the impact on expected pension income for representative members of five different scenarios.
The stress test for DB and hybrid schemes will consider the following hypothetical situations:
- a negative demand shock, beginning in European equity markets and spreading to other asset classes, which would result in a fall in risk-free yields and a fall in prices of riskier assets
- as above, but together with a negative supply shock to commodities markets, and an increase in inflation expectations
- a 20% reduction in mortality rates
The stress test will be carried out first on the current national prudential basis – i.e. the Scheme Funding regime for the UK. However, EIOPA is keen to be able to compare results between member states, and has also requested that schemes provide results on its proposed holistic balance sheet approach.
How fortunate indeed that EIOPA has found an immediate use for a concept which stakeholders had dismissed as unworkable! Much of the criticism of the earlier impact assessment focused on the fact that EIOPA had not indicated how the figures calculated might be used by regulators in connection with scheme funding.
Alongside the stress test, EIOPA has therefore published a quantitative assessment which will investigate how its proposed holistic balance sheet might work as a supervisory tool. This will require schemes to put a value on not only the scheme’s liabilities, but the value of sponsor support.
Liabilities will need to be calculated on both a 'risk-free' and 'expected return on assets' approach and will include a risk margin. Schemes will also need to calculate a possible solvency capital requirement which would take into account the risks faced by the scheme.
The results will be used by EIOPA to inform its advice to the EC on harmonised solvency requirements for pension schemes.
EIOPA says that it has not pre-judged the outcome of the exercises, but it would seem reasonable to conclude there is still a very real risk of funding considerations being put back on the legislative table. The stress test is intended to be a separate exercise to the quantitative assessment, although it will use similar calculations, and EIOPA could use the results to support its rationale for change. It is therefore important that the UK position is fairly represented.
It’s not the winning, but the taking part that counts?
While participation is voluntary, employers and trustees may find the results of the stress test an interesting demonstration of the risk involved in running a pension scheme.
Participating in both exercises would also give employers and trustees the opportunity to see the challenges they might face if an EU-wide solvency regime were to be introduced - and to feed back to EIOPA how these proposals might not be workable in practice!