IORP and Solvency II: European fund management industry must adapt or die
Depositaries are all the rage in Europe. Hedge fund managers must appoint them under the Alternative Investment Fund Managers Directive (AIFMD).
Mutual fund managers have had them for a while, but their responsibilities are being increased under the fifth iteration of the Undertakings for Collective Investment in Transferable Securities Directive (UCITS V). Under the March 2014 version of the Directive on Institutions for Occupational Retirement Provision (IORP Directive), due to come into force in member-states of the European Union by 31 December 2016, even defined contribution pension schemes in Europe must appoint a depositary bank, with responsibility for safekeeping and oversight of the assets of the fund.
The real problem in European pensions, however, is not the safety of the €2.5 trillion of assets they own. It is solvency. This is why the original revision of the IORP Directive, unveiled as a white paper in March 2012, proposed a "holistic balance sheet," which aimed to measure accurately the assets (investments plus the support of the plan sponsor and any insurance underpinning) of European pension funds against their liabilities (conditional as well as unconditional benefits payable plus a risk margin for error). The methodology projected such massive deficits in some important countries that it was howled down by five national governments (the Netherlands, the United Kingdom, Germany, Ireland and Belgium) in conjunction with the whole of corporate Europe and the organised pensions industry.
By May 2013, the European Commission was forced to announce that it was postponing the publication of any further advice on a common European funding regime for pension funds. The new IORP Directive, published in March 2014, focuses instead on that great cant issue of our time: governance. The various measures – risk evaluations, professional trustees, remuneration rules, reporting and of course depositaries – will not help to plug funding deficits. In fact, they will add €22 per member to European pension schemes in implementation costs alone, and recurring costs of another €0.27-0.80 per annum. That might not sound like much, but with 75 million Europeans in occupational schemes, better “governance” will levy a one-off tax of €1.65 billion on European pensions and an annual tax of €20-60 million.
The funding issue has not gone away, of course. Even the March 2014 version of the IORP Directive, despite its focus on governance issues, retains the obligation laid on pension schemes to be fully funded at all times. The European Insurance and Occupational Pensions Authority (EIOPA), which invented the “holistic balance sheet,” is presently engaged in a data-gathering exercise before publishing a revised version of the same idea. It is impossible to escape valuing assets and liabilities based on market prices. The trick is to give under-funded schemes enough time to adjust their assets and liabilities to reality.
In this respect, one approach being touted as a possible model for a future funding rule-set for Europe is the Financial Assessment Framework (FTK) laid down in 2008 by the Dutch central bank for the domestic pension funds it regulates back. A revised FTK, which comes into effect from 1 January 2015, stipulates that the market value of the investments of a pension fund, when measured against the net present value of future liabilities, must match to a confidence level of 97.5 per cent in any one year - after taking account of administrative costs.
Funds that end up with a funding shortfall under the FTK methodology have to draw up a recovery plan within months, and plug the deficit within three years by some combination of higher contributions and lower benefits. Most importantly, a riskier and less liquid Dutch pension fund portfolio now incurs a capital penalty because the “own funds” ratio increases in line with the riskiness and illiquidity of an investment portfolio. If that sounds familiar from the banking and insurance industries in Europe, it is not a coincidence.
In particular, the parallels between the technical regulation of pension fund solvency and the technical regulation of insurance company solvency in Europe are not merely suggestive. The European regulators are seeking explicitly to bring the requirements of pension funding into line with the funding requirements set out for insurance companies in the Solvency II Directive. (The governance provisions of the IORP Directive are also based on the Solvency II text.) Effectively, the regulators are imposing on pension funds and insurance companies capital adequacy and liquidity requirements of a similar kind to those now being imposed on the banking industry under the Basel III regime, and with the same objective of mitigating systemic risk.
What this means for pension funds and insurance companies – and by extension their fund managers – is that regulation is no longer simply a compliance challenge. Once regulators start interfering in the funding of liabilities, regulation becomes a strategic business challenge for institutional investors and the firms which advise them. Fund managers are obliged to report investments to their clients in far greater detail, and more frequently. Asset allocators are forced to change the mix of assets in which a fund is invested, including a reduction in exposure to less liquid alternative asset classes.
This is unavoidable because it is part of a wider agenda. The framers of the IORP Directive in particular see it as part of a decisive shift in European investing away from the tradeable equity securities beloved of fund managers and investment banks towards longer term infrastructural projects, including asset-backed securities based on them. Until now, those projects have relied heavily on bank finance, whose ready availability regulators are seeking to suppress. It is difficult to discern sometimes, but there is a coherence to the various regulatory initiatives affecting the financial services industry in Europe: less money market funding plus more bond market funding plus less credit and more equity equals a more German, and therefore more stable financial system. European fund managers must adapt to this structural change, or exit the business.