The European end game: sooner than you think

When confronted by prospective European legislation, the business community tends to one of two responses. The first is that any new requirements are a long way in the future, and the proposal will change anyway. The second is to get lost in the fog of Euro speak and miss the underlying direction of travel. The long-awaited publication of the revised IORP Directive by the European Commission is, however, of strategic significance, and merits a measured and realistic evaluation.

If approved, the replacement Directive will be implemented by 31 December 2016 – about 18 months away. As predicted, the contentious insurance-style solvency and funding requirements do not appear. The Directive does contemplate further change, and EIOPA is preparing further consultation on its cherished holistic balance sheet, but this is good news – for the moment. So can IORP 2 be dismissed as involving administrative change that may be annoying to implement but is essentially box-ticking? No. Emphatically no. The proposals potentially represent a fundamental shift in the regulation and governance of UK pension schemes, requiring a complete reappraisal of the role of pension trustees and more powers for the Pensions Regulator in every aspect of scheme administration, including funding. The proposals are, of course, in draft and subject to change, but it would be a mistake to assume that they will be significantly watered down. The underlying policy is abundantly clear. The Commission considers pension schemes to be a source of financial risk, like any other financial institution. It therefore sees no reason why regulation devised for other institutions should not simply be adapted to a pension context in the interests of financial stability. Its policy response is therefore prescriptive regulation from the centre, with professionalism and uniformity key components in improving accountability and control. While the Commission’s proposals are littered with references to regulation being proportionate and appropriate, and schemes with fewer than 100 members are excluded, experience of current regulation suggests that proportionality is easier to talk about than to implement.

The first major change is the ‘fit and proper’ test. Those managing pension schemes will have to be professionally qualified and of good repute. Under current law, trustees can either be professionally qualified themselves or take advice from those who are. Most pension trustees easily fulfil the good repute test. However, unless there is to be some sort of professional qualification for pension trustees, or professional qualifications not directly linked to pension scheme administration or governance would suffice (which seems unlikely), we could see the end of the lay trustee. This would be a profound change in UK pensions law. Trust law requires fiduciaries to act reasonably and prudently and to take proper professional advice where appropriate, ensuring that a wide variety of experience and skills can be brought to bear in making decisions where there is often no ‘right’ answer. Our system of member representation generally works well. It is not clear that professionalising the process will add anything other than expense and a possible decline in member engagement.

Next is the introduction of a new raft of detailed governance requirements. They include the following:

  • A formal risk evaluation document will have to be prepared and kept under regular review. Consideration of pension risk is not of course anything new, but the requirements are likely to be both inflexible and prescriptive. The obligation to perform a risk evaluation must be updated without delay following any significant change in the risk profile of the institution or of the pension scheme (Article 29.1). Among the matters required to be covered in the risk evaluation are:
    • the effectiveness of the risk management system;
    • the scheme’s overall funding needs;
    • the ability to comply with technical provisions;
    • a ‘qualitative assessment of the margin for adverse deviation as part of the calculation of the technical provisions in accordance with national law’;
    • a description of pension benefits or capital accumulation;
    • a qualitative assessment of the sponsor support accessible to the scheme;
    • a qualitative assessment of the operational risks for all schemes of the institution; and
    • a qualitative assessment of new or emerging risks relating to climate change, use of resources and the environment.
  • Schemes will have to put in place a published remuneration policy. The object of the change is to ensure that remuneration does not encourage excessive risk-taking, a criticism widely levelled at pre-crash banking practice. In a UK occupational scheme context, it has limited relevance to member protection, but has potential for endless agonising about compliance. Would it be sufficient to disclose what are generally nominal levels of trustee remuneration? What about members of the employer’s staff working as pension manager or scheme secretary? Outsourced functions (such as third party administrators) are expressly included, but does it also include adviser fees? What are the ‘proportionate measures aimed at avoiding conflicts of interest’ that must be included in the policy?
  • There must be an effective internal audit function, separate from the risk management function, to review internal control and governance systems with at least one independent person.

The sting in the tail is the wide ranging powers that will be given to national regulators. Their main objective will be member protection but with a requirement to consider ‘the potential impact of their decisions on the stability of the financial systems concerned in the Union’ – thus in the UK trumping existing requirements such as PPF protection and business sustainability. Regulation must cover technical provisions, funding, solvency, investment rules, investment management and ‘conditions governing activities’ and be exercised through a combination of off-site activities and onsite inspections.

The Regulator’s remit and disclosure powers will extend to third party providers and schemes will have to notify the Regulator in advance if they outsource any of their activities. While national regulators should take ‘a prospective and risk-based approach’ their supervisory review process is required to assess the adequacy of governance procedures, to assess scheme risks and to assess the ‘ability of the scheme to assess those risks.’ In a paragraph of huge significance, Article 63.3 provides that the national regulators ‘shall have the necessary powers to require institutions to remedy weaknesses or deficiencies identified in the supervisory review process.’ Even a comprehensive system such as that in the UK deliberately sets limits on what the Regulator can do. The law generally allows those who are responsible for scheme management to take the decisions that matter within a robust regulatory framework. As drafted, the Directive seems to tip us in another direction, under which the Regulator’s judgement of what constitutes acceptable risk or adequate governance is what matters, with the Regulator having power to order the correction of deficiencies it has identified. Solvency II funding could arrive through the back door.

The prescriptive direction of travel in pension regulation is illustrated in new detailed requirements for the format and content of pension benefit statements. Among other things, contributions, guarantees, investment options and performance would need to be covered – all on two sides of A4 paper!

The justification for IORP 2 was originally the promotion of cross-border schemes as a final step in the completion of the internal single market. New provisions are therefore included to make cross-border schemes easier to operate. While useful, there remains limited scope for companies with operations in various EU locations to make their pension provision more efficient. The full funding requirements for defined benefit schemes operating cross border (which, contrary to expectations, have been retained) will continue to deter a general move in that direction.

Member protection, accountability, transparency – who can quarrel with these as proper objectives for IORP 2? It is hard though to see that the new system will be any better than the one we have now, and it will come at a substantial additional cost for UK schemes and business. Lawyers, consultants, covenant advisers and administrators will be busy for years.

The careful and hard won balance of existing UK pensions law will, however, gradually disappear, and with it potentially create a further disconnect between employers and their pension schemes and members. Even if the Pensions Regulator exercises its powers proportionately, and even if its judgement is always right, something will have been lost. And because the holistic balance sheet and solvency proposals still remain on the agenda, the change won’t stop here. The European pensions end game may be sooner than you think.

This article is published in the July 2014 edition of Pensions World.

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