European Regulator proposes new pan- European pensions risk framework

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1 European Regulator proposes new pan- European pensions risk framework Background On 14 April, the European Insurance and Occupational Pensions Authority (EIOPA) issued its opinion paper regarding the risk assessment and transparency of DB pension schemes across the EU. In it, EIOPA has called for the implementation of a standardised risk assessment framework across the EU, using the so called Holistic Balance Sheet concept that EIOPA has developed over a number of years. Summary The opinion paper follows the latest impact assessment conducted by EIOPA (European Insurance and Occupational Pensions Authority) which found a total shortfall of financial assets compared to liabilities (excluding benefit reductions and sponsor support) of 1.2 trillion ( 0.9 trillion) across DB pension schemes in UK, Netherlands, Germany, Belgium, Ireland and Portugal under the proposed framework. The largest shortfalls were in the UK ( 950bn, 750bn); Netherlands ( 140bn) and Ireland ( 50bn). The majority of the UK shortfall is assumed to be met by sponsor support (eg future employer contributions) whereas the majority of the Netherlands and Ireland shortfalls are assumed to be met by reductions to benefits. The 35 page opinion paper can be found here. Further information is contained in Appendix 1. What is the proposed framework? EIOPA s proposed common framework sets out that: Assets and liabilities on the balance sheet have to be valued on a market-consistent basis, with liabilities being measured on a risk-free rate. The balance sheet includes the value of security mechanisms, which include the value to the scheme of sponsor support and, where possible in the event of underfunding, the value of expected benefit reductions In addition there would be a 'standardised risk assessment', which is the sum of a series of predefined stresses, based on a 0.5% probability of occurrence (ie a 1-in-200 year event) How might it impact pension schemes in practice? EIOPA has said that this framework is not intended to replace existing risk management tools and techniques, such as ALM studies, neither does it replace national regulatory frameworks. EIOPA is proposing this framework in order to introduce a common risk assessment framework for pension schemes in the EEA. This will only impact pension schemes if the common framework was introduced into EU legislation, or introduced by individual member states on a country-by-country basis. Neither of these scenarios seems likely in the short-term, and EIOPA has said it is not looking for this to be included in the revision of the IORP Directive (IORPII) which is currently being negotiated in trilogue by European

2 institutions. However EIOPA has suggested that the European Parliament, Council and Commission consider the proposals for future EU legislation. Given that IORP II has taken a number of years to be agreed (and is still not finalised nor implemented) it seems unlikely that EIOPA's proposals, which are likely to require a further Directive, would be introduced on an EU-wide basis for the best part of a decade (if at all). EIOPA's proposal does not advise on harmonising capital or funding requirements. The proposed framework would be used for risk and disclosure requirements. Thus the ongoing funding requirement for schemes would not change as a result of these proposals. EIOPA has stated that this framework would encourage a gradual convergence of national funding regimes, although there does not appear support for this from European pension funds and sponsoring employers. It is likely that, if the proposals are adopted, there would be a change to the additional reporting as part of scheme valuations, including public disclosures. Additional reporting under this new approach could lead to further onerous governance requirements for DB schemes. There is however a proposed exemption for schemes with assets less than 25M, or less than 100 members. EIOPA recommends national regulators be given sufficient powers to take supervisory action based on the outcome of the common framework. Next steps Most pension funds and employers do not need to do anything in direct response to the proposals. However, the proposals emphasise that the focus on governance and risk management has not gone away. We recommend that pension funds and sponsors continue to focus on good governance and good risk management; and that they continue with existing journeys to ensure good progress in this area. The IORP Directive (IORPII), once implemented, will act as a catalyst for further improvements. The reasons for this view are as follows: It is now for the European Parliament, Council and Commission to decide whether or not to proceed with EIOPA s proposals. EIOPA has stated that it does not expect any new requirements to be implemented in time for the revised IORP II Directive, which will introduce new governance and disclosure requirements for DB schemes. Hence, it could be a number of years before these proposals might be introduced (if at all). Aon has had recent meetings with representatives from the European Parliament, Council and Commission. It is clear that there is now a focused effort to agree and implement the revision of IORP II based on the legislative proposals/amendments submitted already by each of the three EU institutions. We think there is still a possibility that this could be agreed by the end of June 2016 (which is when the Dutch government completes its 6 months role as Presidency of the Council of the European Union). Once IORP II is finalised, focus will then turn to implementing IORP II s new governance and risk management requirements at member state level. A high level overview of the areas covered by IORP II is set out in Appendix 2. Once added into member states' legislation, IORP II will result in significant new governance and risk management requirements for many pension schemes in Europe. We anticipate that the European stakeholders will want to see whether or not the requirements of IORP II are effective, before considering alternative risk management proposals such as those proposed by EIOPA.

3 Appendix 1 - Further detail on the EIOPA proposal Background EIOPA s paper is addressed to the EU Commission and Parliament, and advises that the IORP Directive is strengthened with a common framework for risk assessment and transparency for DB schemes. It is not however intended to amend the existing proposal for the revision of the IORP Directive, which is under current negotiation. It follows work undertaken by EIOPA (under its own initiative) on the Holistic Balance Sheet concept, which estimated a shortfall of 1.2 trillion ( 0.9 trillion) across DB pension schemes. The Proposals At this point in time, EIOPA does not advise on harmonising capital or funding requirements. So the proposed framework would be used for risk and disclosure requirements. The proposed framework consists of a market consistent balance sheet, which contains amongst other items, a schemes assets and liabilities valued on a risk free basis. The balance sheet would also include the estimated value of all security mechanisms in place, such as the valuation of support from the scheme s sponsoring company, and the contingent value to the scheme of the PPF. In addition to the balance sheet, schemes would then have to conduct a standardised risk assessment which is the sum of a series of pre-defined stresses: - The stresses are currently proposed as being calibrated to have a 0.5% probability of occurrence. - They include financial stresses such as interest rate, inflation and equity stress, but also some less common aspects such as revision risk the risk of future legislation changes increasing the cost of liabilities EIOPA proposes this to be an annual assessment and the proposed framework is intended to complement rather than replace existing national regulatory frameworks. The outcome of the assessment framework should be publicly disclosed - this would presumably include the valuation of sponsor support, which we believe many companies may take issue with. Any supervisory actions as a result of the output from the assessment would be taken at the discretion of national supervisors (i.e. The Pensions Regulator in the UK), however, EIOPA recommends supervisors be given sufficient powers to take supervisory action based on the outcome of the common framework. EIOPA has proposed that there could be a small scheme exclusion. This is defined as any schemes with less than 100 members, or 25M. This will be welcome news for countries such as UK, Ireland and Cyprus that have large numbers of small schemes A simplified balancing item approach is also proposed, which would be applicable for schemes with strong enough sponsors. Under this approach the need to explicitly calculate the value of sponsor support and other so called security mechanisms is removed, reducing the calculation burden. There would be a preparatory phase before reporting under the new framework would be mandatory, in order for schemes to be able to acquaint themselves with the common framework,

4 understand the requirements and put in place processes for its technical implementation and public disclosure. However, it is not indicated how long such a phase may be. Next steps The paper is only an 'Opinion paper', addressed to the EU Commission, Council and Parliament. These institutions now need to decide whether to progress the proposals. The revised IORP Directive is currently in the final rounds of negotiation and these proposals by EIOPA will not impact these discussions. Presumably, once the IORP II Directive is finalised, the Commission will turn its attention to the consideration of this new risk framework at some future date.

5 Appendix 2 - Revision of IORP Directive (IORP II) On 27 March 2014, the European Commission issued its proposals for a new directive on the activities and supervisions of Institutions for Occupational Retirement Provisions (IORPs). This will affect occupational pension schemes across all Member States in the European Economic Area. The new directive will replace the previous IORP Directive which was adopted in The Council and European Parliament have since published proposed amendments to the Commission s proposals, and these three EU Institutions are now in trilogue negotiations to agree the final text. Once agreed, it is expected that member states will have up to 2 years to implement into national legislation General objective The Commission s general objective is to facilitate the development of occupational retirement savings, and to reinforce IORPs role as institutional investors in the EU s economy. The proposal has four specific objectives: Remove remaining barriers for cross-border IORPs Ensure good governance and risk management Provide clear and relevant information to members and beneficiaries Ensure that supervisors have the necessary tools to effectively supervise IORPs Proposed governance requirements IORPs will need to put in place an effective system of governance which provides for sound and prudent management of their activities. The system of governance shall be proportionate to the nature, scale and complexity of the IORP, and shall be subject to regular internal review. In addition, IORPs will need to put in place: an adequate transparent organisational structure with a clear allocation and appropriate segregation written policies in relation to risk management, internal audit and, where relevant, actuaries and outsourcing an effective internal control system (including administrative and accounting procedures; an internal control framework; and appropriate reporting arrangements) a risk-management system comprising strategies, processes and reporting processes to measure, monitor, manage and report all the risks of the IORP; Risk Evaluation for Pension IORPs will need to identify and evaluate the risks they face in the short and long term. To do this, IORPs will produce a risk evaluation on a regular basis and without delay following any significant change in risk profile. The risk evaluation shall demonstrate: the effectiveness of the risk management system

6 the overall funding needs (taking into account the specific risk profile, approved risk tolerance limits and the operational strategy of the IORP) the ability to comply with the requirements concerning technical provisions a qualitative assessment of the sponsor support accessible to the IORP a qualitative assessment of the operational risks for all schemes of the institution a qualitative assessment of new or emerging risks relating to climate change, use of resources and the environment The risk evaluation should be carried out using methods which are proportionate to the nature, scale and complexity of the risks involved.

7 About Aon Aon plc is the leading global provider of risk management, insurance and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 66,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative and effective risk and people solutions and through industry-leading global resources and technical expertise. Contact information If you would like more information on Aon s position regarding IORP II or EIOPA's proposals, please contact us at: Kathryn Reilly Director, Global Public Affairs kathryn.reilly@aon.com Colin Haines FIA Partner, International Retirement & Investment (UK) colin.haines@aonhewitt.com Richard Cook FIA Consultant, Retirement & Investment (UK) richard.p.cook@aonhewitt.com Thierry Verkest Partner, International Retirement & Investment (Belgium) thierry.verkest@aonhewitt.com Drs. Frank (F.H.P.) Driessen AAG Chief Commercial Officer, Aon Hewitt Netherlands frank.driessen@aonhewitt.com Disclaimer Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. Aon Hewitt Limited is registered in England & Wales. Registered No Registered Office: 122 Leadenhall Street, London EC3V 4AN Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority