P O S I T I O N P A P E R

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P O S I T I O N P A P E R

Pensioenfederatie Prinses Margrietplantsoen 90 2595 BR Den Haag Postbus 93158 2509 AD Den Haag T +31 (0)70 76 20 220 info@pensioenfederatie.nl www.pensioenfederatie.nl KvK Haaglanden 40411428 Triodos Bank 212407368 DATU M: 12 februari 2013

ONDERW ERP: Position Paper on First Quantitative Impact Assessment run by

Federation

the Dutch Pension Funds (February 2013)

More Quantitative Impact Studies (QIS) necessary in order to test the Holistic Balance Sheet (HBS)-approach as a building block of IORP-revision

Executive Summary

Nine large pension funds (both sector wide multi-employer pension funds and company pension funds) in the Netherlands have executed the QIS for pension funds. The national prudential supervisor De Nederlandsche Bank (DNB) has coordinated this QIS exercise.

Based on this QIS the Federation of the Dutch Pension Funds (the Federation) does not see the need for harmonised capital requirements across the

European Union (“EU”) as intended by the European Commission (the

“Commission”). As a consequence the Federation considers harmonisation in this respect not desirable, it may even lead to a fall in the quality of

supervision in one or more Member States. Based on the experiences of the nine participating pension funds, the Federation has the following

observations and comments on the QIS and the suitability and potential consequences of the HBS-approach.

QIS will not provide sufficient and adequate input for a well-developed IORP-revision

- Now that the input for this QIS has been submitted, the Federation has the

view that it contained many serious shortcomings. Many items (e.g. sponsor support, pension protection schemes, discretionary benefits and confidence levels other than 99.5%) need further research. This was also stated by EIOPA in the draft specifications of the QIS as submitted to the Commission on 2 October 2012.

- As a result, and also because the accompanying supervisory framework

has not been decided yet, the outcomes of the QIS will not provide an adequate insight in the impact in practice of the HBS-approach.

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- Furthermore, the timeframe of only two months for the completion of this

QIS was far too short in the opinion of the Federation, particularly in view of the technical complexity of the assumptions to be adopted, the calculations to be run and the fact that EIOPA and DNB could not always provide for timely and adequate answers on questions from participating pension funds. This has worked out detrimentally on both the accuracy and comparability of the QIS calculations and (hence) the results presented by the participating pension funds.

- As a consequence the Federation considers that it would be ill-advised if

EIOPA and the Commission were to base a future IORP-revision on these results (only).

Many serious doubts about the suitability in practice of the Holistic Balance Sheet approach

- The Federation concludes on the one hand that the HBS-approach seems

intellectually tempting and may have certain advantages.

- On the other hand the Federation has serious doubts about the suitability

and applicability in practice of such an approach. These doubts are based on various factors:

1. Model risk cannot be avoided by using this approach. This is due to both the subjective nature

of many of the assumptions which have to be made and the high complexity of this approach. In particular the significant differences in components of the HBS in different countries and the differences in the assumptions or

interpretations used in calculating the value of these components will lead to different valuation outcomes and prudential conclusions. Furthermore several components of the HBS, e.g. sponsor support, are difficult to measure and as a result not unambiguous. Additional model risk is due to various aspects such as (i) the strong dependence on credit ratings, (ii) the circumstance that some pension funds use deterministic calculations whereas other pension funds use stochastic valuations and (iii) the fact that valuation of options (which might be impacted by the supervisory framework) on different moments can lead to completely different outcomes.

2. There are serious doubts whether the HBS will ever become a suitable supervisory instrument, even if an adequate solution can be found for

tackling these varying assumptions and other forms of model risk. The interaction between elements in the HBS and the Solvency Capital

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inconsistency” resulting from the proposal that pension funds should include conditional indexation in their liabilities. Such inclusion may result in a need to cut back accrued pension benefits, in particular when the pension fund will be confronted with a funding deficit as result of increased liabilities. This would be undesirable and “counterintuitive”, because pension rights would then be decreased on the short term in order to enable the granting of additional pension rights on the long term.

- Finally, the Federation concludes that, even if these problems would be

solved and the HBS-approach would develop into an adequate European harmonised supervisory instrument, it could turn out that this approach will not be the optimal supervisory framework for Member States at European level. In the Netherlands, this approach would not be an improvement compared to the current supervisory framework (Financieel Toetsingskader, FTK). The FTK is less complex and results in a clear understanding of the financial position of a Dutch pension fund.

Commission should undertake more than one QIS-study

- Although the Federation has serious doubts, as stated before, on whether

the HBS-approach will ever become a feasible supervisory instrument, the Federation strongly advocates that the Commission should, in case it decides to continue with this approach, undertake more than one QIS-study at

Lamfalussy Level 1 (with sufficient timeframes) on the quantitative effects of the HBS-approach specifically and on the IORP-revision in general.

- These studies should also be used to improve, if at all possible, the

current conceptual framework of the HBS-approach and/or to test alternative approaches (for example continuity analyses, ALM-studies and stress tests). 1. Introduction

In the period from 16 October until 17 December 2012 pension funds and national pension supervisors in eight European countries (including the Netherlands) have, on request of EIOPA, performed an extensive Quantitative Impact Study (QIS). The purpose of the QIS is to investigate the potential impact of the inclusion of a Holistic Balance Sheet approach (HBS) in the draft proposal for an intended revision of the IORP Directive in 2013. The HBS-approach, is seen as an instrument in a new harmonized method of

supervision. This approach enables pension funds to assess and to attribute a value to the steering mechanisms (sponsor support, increasing contributions)

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and adjustment mechanisms (conditional indexation, cutting back pension rights) in their balance sheets.

This QIS, which is part of the process initiated by the European Commission to review the IORP Directive, was aiming at assessing the financial impacts of different sets of options for the valuation of the constituting elements in an HBS and the calculation of capital requirements as well as at dealing with the quantification of the security and benefit mechanisms existing in different EU Member States.

In the Netherlands the QIS has been executed by 9 large pension funds (both sector wide multi-employer pension funds and company pension funds) and has been coordinated by the national prudential supervisor DNB.

2. HBS-approach not (yet) workable as a supervisory instrument The HBS should, in the view of the Commission, enable a harmonized prudential regime for Institutions for Occupational Retirement

Provision(IORP), which means that it will be used by IORPs and supervisors to establish funding requirements. A harmonized prudential regime is

considered a requirement for achieving comparability between IORPs vested in different European Member States under widely diverse social, labour and fiscal legislations. If comparability would turn out to be limited or even impossible the HBS will not be workable as a supervisory instrument at the European level.

It is most unlikely that the HBS can meet the requirements of a robust harmonized prudential regime for all IORPs in Europe. There are several reasons for this.

2A. HBS-items (1) are not unambiguous, (2) include model risks, (3) differ between countries and (4) are based on underlying assumptions which cannot be harmonized

2A.1 Some components of the HBS are difficult to value and are debatable Several components of the HBS are difficult to value. Sponsor support is a good example. As indicated in the specifications for the QIS this should be done on the basis of the financial position of the sponsor. This is not always appropriate, due to possible liquidity constraints (e.g. the capital of a sponsor may be locked into non-liquid assets) or competing claims on the available capital. Furthermore many sponsors support more than one IORP and sometimes have IORPs in more than one Member State. Sponsor support of

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the same sponsor can be (double) counted on several HBS’s. Valuing sponsor support for multi-employer plans, public sector and not-for-profit schemes is also not straightforward. Valuing sponsor support in the HBS of an IORP could have consequences for the sponsor, for example in the P&L (See also

Paragraph 4 in this Paper) or in the creditworthiness and the credit rating of the sponsor.

In addition to these drawbacks attention should be paid to the fact that sponsor support (and also pension protection schemes and cutting back on pension rights) have to be considered as regular policy instruments for IORPs in the context of this QIS. It provides a valid starting point in situations where these mechanisms are indeed a regular policy instrument of an IORP, but it is not valid in situations where these instruments serve as an “ultimum

remedium” in practice.

2A.2 HBS-approach contains significant model risk

Given the complexity of the calculations and the many assumptions that have to be made the HBS-approach contains significant model risk:

- Too dependent on credit ratings. In particular in the context of calculating

sponsor support, the strong reliance on the ratings by external rating agencies is a negative factor. Firstly many (small and medium-sized) European companies are not rated at all. And secondly the rating agencies have demonstrated during the financial crisis that they do not always make the correct assessments. In this respect reference can be made to a statement by the ECON-Committee in the European Parliament on 19 June 2012 that “…no EU-law will be permitted to refer to credit

ratings for regulatory purposes”.

- It is unclear under which circumstances an open or closed fund approach

has to be adopted.

- The horizon for valuing the steering and adjustment mechanisms is not

defined. Is a value for a certain steering mechanism in the distant future meaningful at all? Taking more years of future steering and adjustment contributions into account will not per definition improve the HBS (in particular when future pension rights are financed by payments which do not cover the cost prices of these new rights and the premium steering mechanism thus has a negative value), but will certainly lead to larger values (positive or negative) of the HBS-items involved.

- The outcome of the valuation is very sensitive to the assumptions made.

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outcome. These assumptions may relate to various elements of the HBS, e.g. the horizon which is taken into account by the pension fund involved, the parameters to be chosen in the (risk neutral) scenario set and the maximum value of the sponsor support (which may in practice vary between 0 and the full value of the technical provisions).

- Some IORPs - also for the purpose of this QIS - use deterministic

calculations, whereas other pension funds use stochastic valuations. If IORPs are allowed to use different approaches it will be very difficult to compare (the outcomes) of the resulting HBS’s.

- Valuation of options can lead to inconsistent outcomes and fluctuations:

valuation of one and the same option at different moments can lead to completely different outcomes, because the prices of options can fluctuate significantly over time. In addition the supervisory framework can have an impact on the valuation of options. More specific: currently the valuation is mainly driven by the current low interest rate

environment. Is this approach robust in other economic circumstances? This issue will be further elaborated in item B in the Annex to this paper.

- The introduction of an UFR leads to at least three issues:

- Valuation of contingent liabilities and assets requires stochastic

valuation (like risk-neutral valuation), which is inconsistent with an adjusted yield (market) curve using an UFR.

- The introduction of a fixed (ultimate) forward rate will have impact

on the volatility of interest rates.

- After applying a shock scenario sets are difficult to calibrate.

These aspects will be further elaborated in item C in the Annex to this paper.

2A.3 Significant differences in components of the HBS in different Member States

(i) The relevant items in an HBS differ significantly from country to country. For example in some Member States pension protection schemes play an important role. In other Member States pension protection schemes do not exist at all. Other examples are sponsor support, cutting back benefits and conditionality of pension increases. This significant degree of flexibility will be at the expense of the transparency, comparability and insight.

(ii) But even if an HBS-item is relevant for IORPs in several Member States the results cannot be compared in a simple and unambiguous way. The assumptions used in calculating the value for that particular entry may differ significantly

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between Member States, as the Federation learned from contacts with

participating IORPs from other Member States in the QIS. This also implies that equal steering mechanisms may very well lead to different prudential conclusions from Member State to Member State, depending on the assumptions made and the relevant national social, labour and tax law. Furthermore, based on the experiences from the Dutch pension funds which participated in this QIS, even for similar IORPs within the same country the results and thus prudential conclusions can differ due to different assumptions or interpretations. In other words, in such a situation various calibrations which are all market-consistent will be possible.

(iii) The legal context (the relevant national social, labour and tax law) and the specific characteristics of the IORP (e.g. size of the pension fund, size of the sponsor and average age of the members) play an important role in valuing a HBS properly.

These differences between Member States may lead to the undesirable

consequence that the HBS-approach, even if this would develop into an adequate European harmonized supervisory instrument, will not turn out to be the optimal supervisory framework for one or more Member States. In the Netherlands this approach would not be an improvement compared to the current supervisory framework FTK for pension funds. In the FTK, market valuation of the assets and the liabilities, as intended by the Commission, has already been introduced. This has turned out to be an improvement compared to the previous supervisory regime in the Netherlands, but also carries disadvantages. The Federation would like to recommend that the lessons learned in the Netherlands from these

disadvantages, e.g. the risk of a short term focus (See item A in the Annex to this paper), will be taken into account by the Commission in the revision of the IORP Directive.

2A.4 No harmonization possible in underlying assumptions

The HBS provides an account of many entries on both the liability and asset side of a balance sheet with many degrees of freedom in valuation. Many assumptions have to be made before valuation can be made. Small variations in assumptions may lead to significant shifts in the balance sheet. Since considerable variations in assumptions already occur between IORPs operating in the same Member State, these variations will increase further in respect of pension funds vested in different Member States. A realistic value for an assumption in one Member State will not automatically be a realistic value in another. As the HBS has to be used in

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many Member States it is very unlikely that a set of assumptions can be defined meaningfully for the entire EU.

2B. Serious doubts on suitability of the HBS-approach as a supervisory instrument

The Federation has serious doubts whether the HBS-approach will ever

become a suitable supervisory instrument, even if the calculated items may be unambiguous. These doubts are based on various arguments, which will be further explained below.

2B.1 Interpretation and concrete regulatory consequences cannot easily be harmonized

In practice, identical solvency capital requirements may not work out the same in practice because of different regulatory consequences in Member States. Because of innate differences between the specific economic situations in Member States, identical deficits in the coverage ratios of IORPs may lead to different policy reactions. As an example, an IORP vested in a Member State where IORPs are in general relatively well funded may find it easier to enforce additional recovery payments than an IORP vested in another Member State where deficits are in general very significant. Simply because of the economic impact that large and frequent recovery payments will have on the sponsoring companies, it may turn out to be impossible to enforce the necessary actions. This becomes even more restrictive if additional differences in legal possibilities exist. As an example, it is simply not possible to reduce benefits in the UK, while it is a possibility in the Netherlands. If identical solvency capital requirements do not lead to similar policy consequences, the harmonization exercise intended by the Commission is futile.

2B.2 HBS-approach does not give insight in quality of pension deal, but only in “holistic” solvency position at a certain point in time

The HBS as proposed does not give insight into the quality of the pension deal for an individual participant, but only into the holistic solvency position of an IORP: it will test whether the financial policy of the IORP is sustainable. For example, in the case of a ‘complete’ pension contract (i.e. including a clear agreement beforehand on how surpluses and deficits will be shared between the different stakeholders) the HBS will, by definition, lead to a holistic funding ratio of 100%: a strong decrease of the value of the assets will automatically be compensated by increases of the value of both the steering

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mechanism of sponsor support and/or the adjustment mechanism of

decreasing the pension benefits. In this case the 100% funding ratio will have less information value than an identical ratio in a traditional balance sheet of a pension fund.

2B.3 Interaction between future balance sheet items and the current Solvency Capital Requirement

It is highly questionable how the “Holistic funding ratio” and the required Solvency Capital Requirement (“SCR”) should be interpreted. This is a result of the combination of copy-pasted elements in the Solvency II Directive - for example the SCR - and the unique characteristics of IORPs (security and adjustments mechanisms) in one and the same balance sheet. Within the HBS, there are on the one hand the “normal” balance sheet items like current assets and liabilities. On the other hand there are balance sheet items which depend on future policy actions, the security and adjustment mechanisms; these mechanisms are meant to improve the funding ratio if the ratio of current assets to current liabilities is too low. In the HBS-approach, these

mechanisms are included in the balance sheet and at the same time they impact the SCR.

This can be demonstrated by an example of an IORP with an insufficient “holistic funding ratio” and a deficit of 100 million Euros in order to comply with the SCR. In this situation an additional payment by the sponsor of 100 million Euro will be impossible, because all the future security and adjustment mechanisms are already valued in the HBS. Furthermore, such an additional payment will not be sufficient because the increase of the level of assets by 100 million Euro will automatically (i) decrease the value of sponsor support, (ii) increase the level of mixed benefits and (iii) decrease the level of ex-post benefit reductions. This will result in a new deficit.

2B.4 New supervisory framework impacts on the policy of a pension fund and its financial position, “dynamic inconsistency”

The main problem with the HBS is not of a technical nature, but is more fundamental. This problem results from the fact that under Solvency II insurance companies have to make a reservation for all conditional benefits. For those benefits that are conditional on an external reference value (for instance an interest rate or a stock market index) this reservation makes perfect sense as companies should be able to keep their promise at all times. If the promise is conditional on the financial situation of the company itself

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however, a reservation is not to be recommended for at least three reasons. Firstly, a reservation is not necessary in order to fulfil the claim. Either the company makes a profit in which case it can finance the promise (profit sharing in the case of insurance companies; conditional indexation in the case of pension funds). Or the financial position is not good in which case no extra payments have to be made. Secondly, the provision makes risk-taking less attractive as the option value of the conditional benefit increases with the volatility of the asset mix. This incentive to reduce risk will be both harmful for the participants of the fund/company as indexation will become less likely, and for the society as a whole as less risk-baring capital will be

available. Thirdly, the reservation results in a dynamic inconsistency. Suppose an IORP has a deficit due to inclusion of the conditional indexation. In case of a company IORP with a strong sponsor, the fund may get additional

contributions in order to close the initial deficit. However, as the financial position of the IORP improves, the probability of future indexation increases, and thereby the value of the indexation option. Consequently, the IORP is again in deficit and new contributions have to be made. This loop of

increasing contributions and resulting increasing indexation option values will continue to the point where indexation is almost fully funded ex ante. This practice runs counter to the intention to give conditional indexation and not unconditional.1 If there is no strong sponsor to back up the IORP the

consequences of a deficit due to the conditional indexation are even more severe. The only remaining steering mechanism might be to cut back pension rights immediately in order to finance the promise to give indexation in the future. As before this will result in further cuts as the improved financial position increases the indexation option value. The HBS tries to solve this problem of Solvency II by extending the balance sheet with the conditional steering mechanisms IORPs have at their disposal in bad economic times. The first two problems are hereby compensated, although it is highly unlikely that this compensation is exactly of the right order of magnitude. The dynamic inconsistency remains a problem as all option values on the HBS are a function of the financial position of the fund.

So the HBS embedded in a revised IORP Directive will have an impact on the policy of a pension fund. Changes in policy will have an impact on the

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The same mistake has been made in the Dutch FTK legislation. The harm of the flaw is hereby mitigated by not requiring a provision for mixed benefits. Consequently, as long as the indexation rules are not fixed, no reservation has to be made. In this case, the main disadvantage of the rule is that transparency on indexation is not allowed.

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adjustment- and/or steering mechanisms of an IORP and as a consequence on the financial position of this IORP. And this will certainly have an impact on the financing policy of the IORP, which may again provoke the aforementioned consequences. As such an undesirable “circular” or “loop” effect is created. 2C. HBS-approach may have added value as an internal management or information tool

Notwithstanding the comments and observations above, the Federation would like to comment that this approach may have an added value in the second pillar (qualitative requirements, including risk management) of a revised IORP Directive. In that context the approach may serve as an internal management or information tool (as also stated by EIOPA2) rather than as a standard

model, providing more clarity than currently on the interests of the different stakeholders in an IORP (employers, employees, retirees).

3. QIS does not provide adequate information for an IORP-revision; more than one QIS-study needed

The QIS will certainly not produce outcomes which can be used as an

adequate basis for an IORP-Directive revision. This is due to several different factors as will be further explained in this paragraph.

3.1 Prudential framework still unknown

As also stated by EIOPA3, the impact in practice of the HBS-approach is not

clear because the accompanying supervisory framework has not been decided upon yet. In the same context EIOPA referred to this issue as a subject of political decision making. For example the length of the recovery periods, which could have a strong impact on (the measures to be taken by) an IORP, has not yet been defined. The QIS has been performed based on current prudential regulations. Therefore, the results of the QIS are only valid for these regulations. Implementing a different prudential framework will lead to different pension fund policies. This will have an impact on the valuation of the options. The option values which have now been calculated in this QIS could change significantly when a different supervisory framework would be applied on the same HBS.

2 EIOPA, Technical Specifications QIS of EIOPA’s Advice on the review of the IORP Directive, 2

October 2012 (EIOPA-BOS-12/085), par. 1.5.9

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EIOPA, Technical Specifications QIS of EIOPA’s Advice on the review of the IORP Directive, 2 October 2012 (EIOPA-BOS-12/085), par. 1.5.12

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3.2 QIS-outcomes not representative

The Federation doubts seriously whether the QIS and its outcomes are representative.

In the first place only 8 of the 27 EU Member States have participated in the QIS, as also announced by EIOPA in its Press communiqué of 16 October 2012. Furthermore in these 8 Member States only a limited number of IORPs participated in the QIS. In the Netherlands 9 representative pension funds have executed the QIS on their own and the national supervisor will feed back aggregated data to EIOPA. In the UK the national supervisor has executed the QIS on an aggregated basis, with no significant input from individual IORPs. In the second place, as also explained in Paragraph 2 of this Paper, running the QIS is complex. It has been established that these calculations cannot be performed by many (small and medium sized) IORPs and outsourcing this to external experts proves to be a very costly affair. As a consequence these categories of funds have not participated in the QIS.

Considering the fact that there are approximately 144.000 IORPs in the EU and that the participation in the QIS was very limited (with a very low participation by small and medium-sized IORPs), it is highly questionable whether the outcome can be considered representative.

3.3 Many QIS-items need further clarification

The real impact cannot be measured by this QIS, since there still are many items which need further research. This was also stated by EIOPA in the draft specifications of the QIS as submitted to the Commission on 2 October 2012. In these specifications EIOPA expressed that there are many issues which have not yet been addressed and which could not be resolved within the timeframe allowed for this QIS. EIOPA added that there are also several issues which need further work, e.g. sponsor support, pension protection schemes,

discretionary benefits and confidence levels other than 99.5%. As an example, an adequate way of calculating the value of the sponsor support in the case of a multi-employer pension fund is missing as also explained in Paragraph 2 of this paper. This is very relevant because in EU Member States many of such funds exist, e.g. the Dutch industry-wide pension funds (with sometimes more than 10.000 non-listed employers) which provide the pension for approximately 90% of the Dutch working population.

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3.4 Many options investigated, adequate and one-dimensional outcomes impossible

In the QIS, EIOPA has assessed the financial impact of a large number of different sets of options for the valuation of the HBS and the calculation of the capital requirements. The participating IORPs were requested to fill in many templates each of which contained many assumptions. More specific, IORPs were requested to calculate 3 basic scenarios: an upper bound scenario (implying the strictest of conditions), a benchmark scenario and a lower bound scenario. In addition, the impact of other parameters in the basic scenario have been investigated. EIOPA will also calculate the impact of these scenario’s on the basis of confidence levels of 97.5% and 95%, whereas the QIS-calculations had to be executed at a 99.5 % confidence level by the participating pension funds.

As a consequence of this wide variety of options it will, by definition, be impossible to measure the impact of an IORP-revision on IORPs in an adequate and one-dimensional way by means of this QIS.

3.5 Reliable aggregation of data not possible

As announced by EIOPA the QIS has been executed in several ways: by IORPs, by actuarial firms on behalf of IORPs, by the national supervisory authorities (using either real of aggregated data) or a combination thereof. For example, in the Netherlands some pension funds have run the QIS themselves, some other pension funds had the QIS executed by actuarial firms, and the Dutch national supervisory authority DNB has aggregated the data subsequently. As a result of these (from both a principle and practical point of view different) diverse approaches in execution of the QIS it will not be possible for EIOPA to adequately aggregate, analyse and compare the QIS-outcomes of different IORPs within and between participating Member States.

Also, from recent contacts between participating pension funds within the Netherlands and from several Member States it emerged that these IORPs have all been using different assumptions and methods. This can be considered as another factor hampering an adequate aggregation and comparison of the QIS-outcomes.

It is questionable whether these aggregated outcomes will give a clear insight in the effects of the HBS and SCRs on the level of individual IORPs, even if the problems with respect to the aggregation of QIS results can be resolved in an acceptable way,

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3.6 Timeframe QIS too short

The timeframe in which this QIS had to be performed turned out to be (far) too short, in particular taking into consideration the high degree of technical complexity of the assumptions to be adopted, the calculations to be run and the circumstance that DNB and EIOPA could not always provide for timely and adequate answers on questions from participating IORPs. If more time had been available more sensitivity analyses could have been performed by the participating IORPs. This would have contributed to the quality of the QIS as a whole. In this context the Federation would like to add that it is fully aware of the circumstance that the heavy time constraints in this QIS were also very difficult for EIOPA and DNB themselves.

Nevertheless, the Commission seems to be pressing for using use these (incomplete) QIS-results as a major input for the next steps in the IORP-revision process: (i) its macro-economic impact assessment of this IORP-revision, (ii) a study by the ECB on the impact on the financial stability in the EU and (iii) its own judgement of the final details of a revised IORP Directive. In the view of the Federation, this would not be a good way of moving forward, taking into account the shortcomings of this QIS as mentioned above. 4. An IORP-revision based on the HBS-approach will have adverse consequences for the European economy

4.1 HBS-calculations are very complex and thus costly and time consuming Firstly, and as already explained in this paper, the valuations and calculations in the context of an HBS-approach are very complex and as a consequence very time consuming and costly. The Federation has serious concerns that many (in particular small and medium-sized) IORPs will not be able to do these calculations and valuations or to do these at unreasonable high costs only. This may hamper the expansion of supplementary pensions in the EU and go against the goal of the Commission to enhance the role of (funded) supplementary pensions significantly as laid down in the White Paper on Pensions.

If nevertheless the HBS-approach would be introduced, the Federation would advocate the implementation of a simplified model for small and medium-sized pension funds. The Federation would be ready in this case to provide its expertise and experience concerning a simplified model in the FTK.

4.2 Unwanted consequences in the relations between pension funds and sponsors might be provoked

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Secondly, the HBS-exercise might have unwanted economic consequences in the relations between pension funds and sponsor companies. For example the attribution of high values to sponsor support in its HBS by a pension fund could provoke serious adverse effects in the annual accounts of the sponsor company considering the provisions of IAS 19.

In addition, the HBS-approach implies “explicit” valuation of sponsor support, whereas sponsor support usually is “implicit” and renegotiable in practice. If sponsor support were nevertheless to be valuated explicitly this could form an incentive for sponsor companies to restrain or terminate their sponsor support altogether. This would mean a transfer of risks to the participants of the pension funds.

4.3 Proposed calculation of SCR could imply unwanted changes in investment

behaviour of pension funds

The proposed calculation of the SCR could lead to unwanted incentives for pension funds to fundamentally change their asset mix by moving away from long term investments. The potential decrease in the provision of

risk-bearing capital to European enterprises will hamper economic growth and employment and this will be detrimental to the goals of adequate and sustainable pensions in the EU.4

Within the context of the calculation of the SCR it should also be noted that alternative assets (infrastructure, emerging markets, commodities) are not taken into account as a separate category. This may create an incentive to move investments away from these categories, and could lead to a sub-optimal asset mix which will not be in the interest of the participants of the pension funds.

5. Conclusion

5.1 QIS does not provide adequate input for a well-developed IORP-revision, more impact studies needed

Now that the input for this QIS-exercise has been submitted the Federation has the view that the timeframe for this QIS, was (by far) too short, in

particular taking into account the high degree of technical complexity of the assumptions to be adopted and the calculations to be run. This has worked

4 See also the working paper of the OECD: Severinson, C. and J. Yermo (2012), "The Effect of Solvency Regulations and Accounting Standards on Long-Term Investing: Implications for Insurers and Pension

Funds", OECD Working Papers on Finance, Insurance and Private Pensions, No. 30,OECD Publishing.

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out detrimentally on both the accuracy of the QIS calculations and (thus) the results presented by the participating pension funds. Furthermore this QIS contained many serious shortcomings and there was a lack of clarity. As a result, and also because the accompanying supervisory framework has not been decided upon yet (which can be considered as contrary to the usual legislative process, in which impact studies are done once the proposed legislative framework has become clear), the outcomes of the QIS will not provide for an adequate insight in the impact in practice of the HBS-approach in the Netherlands. As a consequence, the Federation considers that it will be ill-advised if EIOPA and the Commission were to base a future IORP-revision on these results (only). The Commission should therefore undertake more than one QIS-study on the quantitative effects of the HBS-approach specifically and on the IORP-revision in general.

5.2 Serious doubts about the suitability in practice of the HBS-approach The Federation furthermore concludes that, although the HBS-approach may have certain advantages and seems intellectually tempting, there are serious doubts about the suitability and applicability in practice of this approach. This is due to both the subjective nature of many of the assumptions which have to be made and the high degree of complexity of such approach. These aspects cause a significant model risk.

Although the Federation has serious doubts on whether the Holistic Balance Sheet approach will ever become a feasible supervisory instrument, the Federation strongly advocates (as already stated) that the Commission should undertake more than one QIS-study on the quantitative effects of this

approach. These studies could be used to improve the current conceptual framework of the HBS-approach and/or to test alternative approaches (for example scenario analyses, ALM-studies and stress tests).

5.3 Harmonized capital requirements not desirable

Finally, the Federation remarks that it does not see the need for harmonized capital requirements across the EU, as intended by the Commission. One of the main reasons mentioned by the Commission to introduce harmonized capital requirements across the EU is to create a level playing field for IORPs all over the EU. It is very questionable whether the lack of harmonization of capital requirements played a role in preventing Dutch pension funds from extending their activities outside the Netherlands or IORPs from other EU Member States to extend their activities to the Netherlands. At this moment it

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is already possible to establish cross-border IORPs, but interest is very limited. In the view of the Federation harmonization will not change this status quo. In the Netherlands such harmonized approach will not be an improvement compared to the FTK. The FTK is tailor made for the Dutch situation and lacks a lot of ballast of the HBS-approach. The FTK is according to the Federation less complex and results in a clear understanding of the financial position of a Dutch pension fund.

Contact:

Sibylle Reichert

Head of Brussels Office

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Annex

A. Lessons learned in the Netherlands

The introduction of market-based supervision in the Netherlands has brought the following four benefits to the Dutch pension sector: Firstly, pension funds have become much more aware of the importance of managing the financial and other risks on their balance sheets. This was to a large extent triggered by the consistent treatment of valuing both liabilities and assets on a market-consistent basis. Secondly, pension funds have become much more aware of the need for open and clear communication regarding the potential risks and the full nature of the pension arrangement for their participants. Thirdly, the role of operational supervision has gained considerable prominence. Fourthly, the setting of contribution levels by pension funds has become more tightly controlled.

There were however also some supervisory rules which did not elicit desired behavior from the institutions which are being supervised. Dutch pension funds considered it appealing to move to conditional indexation. After all, this means that, for purposes of the solvency test, all liabilities can be discounted at nominal interest rates (instead of the lower real interest rate), which is favorable for the solvency position that is reported to the supervisor. A second unintended consequence was that pension funds started to focus much more on monitoring their one-year seminal solvency position, instead of their long-term real fund position. In some cases, pension funds

implemented Liability Driven Investment (LDI) strategies, where investments exactly match the nominal liabilities. This is not always optimal for the participants since, over the long investment horizons that pension fund participants face, inflation will erode more than half of the purchasing power of the guaranteed nominal cash flows.5 Hence, over long time spans, a

nominal guarantee is not worth as much as it may seem.

What lessons can be learned from this “Dutch case”? Firstly, supervision should strike a balance between securing the short-term financial position of the pension fund and supervision on the long-term ambitions of the fund. Pension fund supervision should not exclusively focus on a short-term

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solvency test (like the Value-at-Risk approach advocated for insurance companies in Solvency II). Secondly, the supervisor should provide pension funds with the opportunity to realize their long-term real ambitions for the participants. There should at least be more communication to stakeholders about expectations and uncertainties in relation to the indexation ambition of a pension fund.

Another lesson learned is that recovery periods should to some extent be flexible. The standard recovery period in the Netherlands for underfunding is three years, but the Minister of Social Affairs and Employment has the option to extend that to five years for all pension funds. This option was exercised during the last crisis. The volatility of markets, leading to a volatile funding ratio, is also a lesson that the Dutch have learned from the crisis. How reliable and relevant is a funding ratio that is based on incomplete and unbalanced markets?6 Waiting

periods or other methods like smoothing could overcome excessive volatility. B. Fluctuating option values

Introduction

Valuation of options can lead to inconsistent outcomes and fluctuations: valuation of one and the same option at different moments can lead to completely different outcomes, because the prices of options can fluctuate significantly over time. In addition the supervisory framework can have an impact on the valuation of options. More specific valuation is now mainly driven by the current low interest rate environment. Is this approach robust in other economic circumstances?

Explanation and elaboration

The HBS-method augments the traditional balance sheet by adding values for the different policy instruments IORPs use. We refer to these new balance sheet items as contingent assets and liabilities.

The contingent assets and liabilities are valued by making projections of the future development of assets, liabilities and the pension fund policy, and calculating the (weighted) average value of the net present value of the cash flows of the policy instruments over a large number of scenarios. These

scenarios are generated from a risk-neutral economic scenario generator (ESG)

6

Pension liabilities are long-term, and the market for very long interest rates (over 30 years) is illiquid or even non-existing.

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calibrated on market prices, to ensure market consistent valuation of the policy options.

The ESG is calibrated on the market prices at the valuation date of a number of derivative instruments, such as put and call options and swaptions of different maturities and issuers. Problems may occur with the ESG. If these market prices fluctuate substantially between valuation dates, this may cause substantial differences in the calibration of the ESG, and hence, in the option values that are computed for the policy instruments of the IORP. This then causes substantial fluctuation in the contingent assets and liabilities of the HBS, without any change in the underlying policies.

It should be emphasized that from a technical perspective this is not a

problem, since the option value computed is the best available approximation of the market consistent price. However, it may be very undesirable if these fluctuations in the values of the contingent assets and liabilities (which are not due to changes in the underlying policy instruments) trigger supervisory responses. Therefore, we argue that this issue (and more in general the role of the contingent assets and liabilities in the supervisory framework) requires careful thought.

C. Issues resulting from the introduction of an UFR The introduction of an UFR leads to at least three issues:

- Valuation of contingent liabilities and assets requires stochastic

valuation7, which is inconsistent with an adjusted yield (market) curve

using an UFR. If the indexation is contingent on the available assets versus nominal accrued benefits – as is the case in many Dutch pension fund – one needs stochastic valuation to calculate the value of the contingent assets and liabilities. Let us assume that the value of the assets is 115 and of the nominal accrued liabilities based on the unadjusted market curve is 100, but on the UFR-curve 110. Applying the UFR-curve will decrease the surplus from 15 to 5, with consequences for other balance sheet items as well (most likely, the value of the sponsor support including future

contributions of employees will rise and the value of (conditional) indexation will fall). Changing the value of one balance sheet item will

7

Stochastic valuation, like risk-neutral valuation, is a method to calculate the value of contingent cash flows and is used in financial markets for pricing options. It calculates the market value of the replicating portfolio for these cash flows and makes the pricing market consistent wi th prevailing assets prices in the market.

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make the balance sheet and imbalanced sheet and other balance sheet items will have to be changed as well, deviating from their fair, calculated market value.

- The introduction of a fixed (ultimate) forward rate will have impact on the

volatility of interest rates as well. By fixing the long end of the curve the scenario set used for valuating contingent assets will become inconsistent with market prices for options in the markets (like swaptions). This would imply and require also adjusting or recalibrating the volatility.

- After applying a shock scenario sets are difficult to calibrate. Should one

first apply the UFR and then shock the curve or first shock the curve and then apply the UFR. Shocking the curve and using the UFR at the same time will increase the issue with the market volatility as described at the previous bullet.

Figure

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References

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