February 2013

EDHEC RESEARCH: The EU has designs on you

ArchitectThe European Commission is calling on all its member states to enact pension reforms at country level. François Cocquemas, of the EDHEC-Risk Institute, takes an indepth look at the white paper. The European Commission published a white paper in February last year entitled An Agenda for Adequate, Safe and Sustainable Pensions. It points out some of the salient issues facing European countries in the near future, and proposes some European-level responses to encourage countries to tackle them. In accordance with the subsidiarity principle, many of the reforms need to be enacted at country level.
Nonetheless, the Commission proposes a series of measures at European level, which revolve around three main aspects:
• Information and monitoring: awareness regarding both challenges and best practices, promotion of dialogue between social partners, multilateral monitoring of reforms;
• Harmonisation and portability: promotion of a level playing field with Solvency II through the revised Institutions for Occupational Retirement Provision (IORP) Directive, facilitation of cross-border activities through IORP and Portability Directives, possible inclusion of pensions in the scope of Regulation 883/2004/EC on the co-ordination of social security provision, examination of tax and contract-law obstacles to cross-border pension investment;
• Pension design: codes of good practice for both second and third-pillar pensions, possible EU certification scheme, optimisation of tax and other incentives, raising quality of third-pillar pensions and review of protection against the employer’s insolvency.
The information and monitoring side is unlikely to be controversial, but it can be more or less effective depending on how it is enforced. The more complex aspect, but also with potentially the most dramatic consequences, is harmonisation. The various legal frameworks may be leveraged to instigate profound changes in national systems, and the European institutions need to tread carefully. Finally, pension design raises some good questions. But, at this stage, it misses some important elements specific to retirement products by excessively trying to mimic other prudential frameworks.
With recent research we aim to provide an in-depth response to the proposals and with our three key messages in mind, a move towards hybrid pensions could provide a more adequate conceptual framework for European countries to converge towards. EASE OF REFORM
The current public debates surrounding pensions on the one hand, and budgetary co-ordination on the other, would greatly benefit from being held conjunctly. In all logic, unfunded first-pillar public pensions are largely structural problems due to slow-moving demographics, with a large impact on government-sponsored defined benefit (DB) schemes and social security pension schemes.
Unfunded and underfunded second-pillar pensions also have the potential to weigh on future deficits, as countries may need to eventually bail out some pension plans.
The Commission should, therefore, take advantage of this opportunity and, in the short run, help with citizens’ information and push for national reforms. In the longer run, taking into account unfunded implicit pension commitments in the Stability Treaty should, in our view, be envisaged, as it might be the only way to foster co-ordinated reform across countries. PRUDENTIAL FRAMEWORK FOR PENSIONS
While a prudential framework is certainly needed, it cannot ignore the specific aspects of retirement provision, in particular, when there is a sponsor to provide guarantees.
An insurance company could theoretically go bankrupt at any instant and, therefore, needs short-term prudential rules such as the solvency capital requirement. Pension funds, on the other hand, are truly long-term investors with long-term liabilities.
While a homogenised framework for pension supervision in Europe is needed, modelling it after Solvency II is a mistake. Although insurance providers may want to position themselves in competition with pension providers, it is a misunderstanding of the specific characteristics of pension provision. ASSET-LIABILITY MANAGEMENT
In our view, the Commission should keep in mind that the constitution of any prudential framework needs to go hand-in-hand with the design of better retirement solutions. It is pointless and wasteful to apply prudential rules to poorly-designed strategies.
Current pension fund practices are still largely inadequate, as are the vast majority of third-pillar products. Failing major adjustments, the needs of retirees will not be met.
Far from advocating a one-size-fits-all mandatory solution that would be designed by the regulator, we consider it essential that the industry itself takes action.
But to do so, it needs to be supported by a regulation that understands the specificity of retirement needs and that will incentivise, not penalise, investment solutions that match those needs.
Many pension solutions are using the wrong asset allocation strategies applied to the wrong building blocks. Often enough, they do not provide any form of risk management, or leave it as an afterthought. However, some better approaches have been proposed and thoroughly tested, notably in the form of asset-liability management. To ensure those good practices are used, the regulator has a role setting up the right incentives.
In this area, it is possible to increase pensioners’ security while also benefiting equity holders by moving towards hybrid solutions, notably through the development of subtler surplus sharing rules.
If pensioners are given access to part of the plan surplus, they will be more willing to accept a higher level of risk-taking, which is required to reduce the contribution burden of equity holders.
In the context of the debate about maintaining a “level playing field” with Solvency II it is clear that simplistic short-term constraints will not be beneficial on their own. The welfare cost associated with such a constraint need not be prohibitive, but it requires the implementation of dynamic risk management strategies that are optimal given the constraint.
With or without these regulatory constraints, it appears paramount that funds actually implement and use asset-liability management models, and regularly assess their adequacy and resistance to stress. IMPACT ASSESSMENT
Before proposing new frameworks for pensions with such deep-reaching consequences, it seems vital to assess its impact. A translation of a Solvency II-type regulation to the pension fund industry would require a precise evaluation of the microeconomic consequences on the funds themselves.
The Quantitative Impact Study launched by the European Insurance and Occupational Pensions Authority in 2012 should provide some elements in the context of the revision of the IORP directive, but it seems to mimic the Solvency II approach rather than adapting to the uniqueness of this market.
At the same time, it is essential to also investigate the macroeconomic (so-called “general equilibrium”) effects of any reform. Pension funds are major players in European economies and are bound to become increasingly so, and imposing rules borrowed from another prudential framework should not be taken lightly.
Studying, both quantitatively and qualitatively, the overall impact of introducing new rules should be the touchstone of any new regulatory initiative.
A coherent state-of-the-art framework for risk management practices is currently emerging. Rather than imposing an inadequate framework that will likely hamper the development of appropriate pension solutions, regulation should design and evaluate the best incentives for a much wider adoption of these asset-liability management techniques.
After all, they are the only way to reconcile the adequacy, safety and sustainability that the Commission is aiming for. François Cocquemas is a research assistant at EDHEC-Risk Institute ©2013 funds europe

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