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Background for policy advisors, managers, politicians and academics September 2012 | no. 1 Increasing the sustainability of European pension systems How can eurobonds help to solve Europe’s problems? Wim Boonstra Chief economist at Rabobank Netherlands The impact on pension funds of a mandatory clearing regime for OTC derivatives Nicole Grootveld COO NL Cardano Zöhre Tali Bas Zebregs APG Asset Management The European Pension Agenda Jurre de Haan Wilfried Mulder Corporate Strategy & Policy APG IORP: Some chances and challenges ahead Pieter Omtzigt Member of Dutch Parliament The Dutch and British pension sector Converging towards a steady state? Ruben Laros Stefan Lundbergh Innovation Centre APG Introduction Contents Introduction How can eurobonds help to solve Europe’s problems? 3 4 Wim Boonstra Chief economist at Rabobank Netherlands The impact on pension funds of a mandatory clearing regime for OTC derivatives 10 Nicole Grootveld COO NL Cardano Zöhre Tali Bas Zebregs APG Asset Management The European Pension Agenda 18 Jurre de Haan, Wilfried Mulder Corporate Strategy & Policy APG IORP: Some chances and challenges ahead 26 Pieter Omtzigt Member of Dutch Parliament The Dutch and British pension sector - Converging towards a steady state? Ruben Laros Stefan Lundbergh Innovation Centre APG 32 It is my great pleasure to present to you the new edition of Pension Background, the English version of Pensioenachtergrond. This is a special issue of our regular magazine, reflecting the great importance that APG attaches to developments in the EU. Although from a subsidiarity point of view pensions and pension arrangements remain predominantly a national policy issue, there are important aspects linked to EU policies to be taken account of, such as the functioning of the internal market and the stability of the financial system. The ongoing crisis in the eurozone makes it even more pres– sing to make progress on these issues. Therefore, this edition provides a good mix of articles related to the currently unfolding euro crisis and the European Commission’s proposals for a new regulatory framework. One of the key elements in solving the euro crisis is debt mutualisation by the introduction of eurobonds, as Wim Boonstra of Rabobank argues in this issue. At the same time, new EU regulation on derivatives has been adopted to increase the transparency of the derivatives markets and to mitigate systemic risk. Zöhre Tali and Bas Zebregs of APG and Nicole Grootveld of Cardano explain the impact of this regulation on the pension sector, a sector that is known for enhancing financial stability by having a longterm view on investments. The current crisis is also one of the factors putting increasing pressure on the sustainability of pension systems. The European Commission therefore proposes new regulation for pension systems. Jurre de Haan and Wilfried Mulder of APG explain some highly topical developments in European pension policy making and their possible implications for the Dutch pension system. Pieter Omtzigt, member of Dutch parliament, provides his view on the proposed revision of the IORP Directive by the European Commission. Finally, this edition concludes with some reflections by APG colleagues Ruben Laros and Stefan Lundbergh on developments in the UK market. In the past, the UK chose a marketbased approach to pension provision, and now the policymakers and the public are coming to terms with the shortcomings of (individual) defined contribution schemes. I would like to thank the authors from inside and outside APG for sharing their views, and I hope this magazine constitutes a worthwhile contribution to the pension debate at large and to the personal and professional insight of you, our readers. Dick Sluimers Chief Executive Officer Pension Background September 2012 no 1 3 Between 1999 and 2008, markets failed to differentiate between public debt within EMU. Only after the collapse of the American investment bank Lehman Brothers did markets increasingly start to factor in differences in risk. Therefore it was only in times of crisis that financially stronger states enjoyed more advantageous funding compared to weaker states. How can eurobonds help to solve Europe’s problems? However, this advantage has been cancelled out almost entirely by the cost of the bailout packages, losses incurred on government bonds issued by problem coun tries and the costs of the recession in Southern Europe, which has impacted on the northern countries, too. As a result, the question of eurobonds has once again found its way to the top of the European political agenda. The problem is that the generic term “eurobond” conceals many variations. Some (e.g. Mario Monti) see eurobonds as instruments to stabilise the EMU. Others (e.g. François Hollande) would want to use eurobonds to boost economic growth. Others still (e.g. Angela Merkel) expect that eurobonds will undermine discipline in weaker countries and push up interest rates sharply for strong member states. However, rarely is the question raised of whether it might be possible to design a eurobond system in such a way as to boost stability and increase budgetary discipline while also offering tangible benefits to the financially stronger states. After all, everything depends on the way a eurobond programme is given shape. This article proposes a temporary programme of shortterm eurobonds (Euro T-Bills), launched by the European League for Economic Cooperation (ELEC). It is argued that a temporary regime of conditional eurobonds, if well designed, can create long-term stability, present policymakers with the right incentives and offer benefits to all participating countries. Criteria for eurobonds Eurobonds are bonds issued by a central European agency in order to finance the participating member states’ national debt.1 A well designed system of eurobonds could help to rein in financial markets and improve discipline. But first we should start with asking questions such as: what do we want to achieve by introducing eurobonds? Is this feasible, and if so, under what conditions? Successful eurobonds should, first, give all countries access to funding under reasonable conditions. Second, they should produce benefits for all participating states, both weak and strong. Third, they should not introduce moral hazard but rather increase budgetary discipline where possible. Fourth, they would preferably be selffunding, so that any problems in future might be addressed without having to bother the stronger member states with them. Fifth, they would ideally strengthen financial stability by breaking the strong financial links in EMU member states between national governments and local banking systems. Finally, the eurobond programme should free the ECB of its interventions in the market for national debt, so that it can refocus its attention on its primary goal: the execution of monetary policy with the ultimate aim of maintaining price stability. Only a eurobond programme which fulfills all these conditions would be acceptable to all member states. 1 Eurobonds are also known as Stability Bonds (EC, 2011) or EMU Bonds (1989; ELEC, 2012). Pension Background September 2012 no 1 5 ‘However, rarely is the question raised of whether it might be pos sible to design a eurobond system in such a way as to boost stability and increase budgetary discipline while also offering tangible benefits to the financially stronger states.’ However, most existing proposals do not meet all these criteria. Moreover, it is also important to realise that the most we may expect from eurobonds is that they might contribute to creating the circumstances under which a policy of stability can be executed. Eurobonds do not relieve countries from the need to reduce fiscal deficits and restore their competitiveness and potential for growth either. set of budgetary rules, to which participating countries would have committed, as well as effective and automatic sanctions for states that breach the agreements. Therefore the proposed T-Bill programme complements the new budgetary rules agreed upon in late 2011. Euro T-Bills: a transitional regime The programme is open to all member states of the eurozone which have so far managed to get by without financial support from the other member states. Countries which are already in need of financial support (at the time of publication Greece, Ireland and Portugal) therefore cannot yet take part. The EFSF is open to those states. In addition to this, the intended policies of the participating countries must first have already been approved under the European semester. Finally it is essential that all the large states participate, including Germany2. The introduction of eurobonds represents a far-reaching redesign of the eurozone. It will take time to work out the details and complete all the necessary political, legal and constitutional procedures. But we are pressed for time: even though the ECB’s LTRO “bought” three extra years, financial markets could still spoil things. This is why the European League for Economic Cooperation (ELEC) is proposing to start with a temporary programme (ELEC, 2012). This programme should be able to provide all the funding the governments of the participating countries need through collectively guaranteed shortterm eurobonds (Euro Treasury Bills). This guarantee should be a cross-guarantee, i.e. every member state guarantees the national debt of all other member states. Obviously, this is only possible if accompanied by a strict Conditions for participation are the following: Solvent countries only 2 Through the programme, participating countries can cover all their funding needs (financing deficit and due debts) over the next four years (2013-2016) through collectively guaranteed short-term bonds (Euro T-Bills). These will have a maximum maturity of 2 years and will be issued by a new agency, the EMU fund. Participating countries will refrain from issuing short-term bonds themselves, but would be free to issue longer-term government bonds without a collective guarantee. Accordingly, if the programme were to be discontinued after four years, the last eurobonds would be repaid after six years, i.e. in 2018, at the latest. Discipline through extra premiums States whose budget deficit exceeds 3% and/or states with a national debt exceeding 60% of GDP would be liable to pay a premium on top of the necessary costs to finance the agency. This premium will vary according to an automated formula in which the relative size of the public deficit and debt is taken into account (Boonstra, 2012). Building up reserves Through the premiums levied, the EMU fund would by definition make a profit, which would be added to the agency’s reserves. These reserves are not meant to be used for bailouts, but intended as a cover for the collective guarantee on eurobonds issued. Even if they have to pay a premium to the EMU fund, the weaker countries will still find this a cheaper solution than having to access the markets on their own. Note that the premium mechanism does, however, begin to discipline these countries much earlier than the financial markets have done in the past. Moreover, states can influence the premiums they are being charged by adjusting their policies in the right direction. Finally, the premiums paid to the EMU fund would be used to build up reserves, where the market’s high interest rates would be collected as a risk premium by investors. More recently, Spain also needed help for its banking problems. Spain (like Italy) is too large to keep out of the system. Moreover, Spain has a good track record in following the rules of the Stability and Growth Pact. Therefore, it would be better to include Spain in the scheme. One could say that a timely introduction of eurobonds would have prevented the Spanish banking problems to run out of Expulsion as an ultimate sanction If states fail to implement the agreed policies, ultimately the decision could be taken to gradually phase them out of the programme. In any case the programme does have a “big stick” waiting at the end, as countries which behave badly can be excluded from participation in a follow-up programme, should this be decided upon. Moreover, in such a situation the cross-guarantees on already issued bonds, as well as the reserves that were built up to cover these, will prevent problems from spilling over into other states to a large degree. This will considerably improve the EMU’s bargaining position against unwilling countries. Advantages and disadvantages Advantages One important benefit is that as a short-term eurbond programme is temporary in nature, it can be introduced quickly. Moreover, it provides the opportunity of learning lessons along the way. Additionally it will allow Europe some time to carefully design any future system and to embed it in law. If a permanent eurobond programme does not function optimally after its launch, it will be extremely difficult to make changes to it, so for this reason alone a trial period in the shape of a temporary programme would be desirable. The programme’s duration would allow states the time to get their policies in order without having to fear financial markets’ reactions from day to day. This period would provide enough time to design the right policies, implement these and demonstrate the policymakers’ sincere intentions of executing them. The temporary nature would also offer a strong and credible sanction against countries which do not adhere to the agreed rules, as they would not qualify for the follow-up programme. The problem of moral hazard can be addressed by means of the premium levied in the internal allocation mechanism, and the possibility to phase a country out of the programme. At the short end of the yield curve, Euro T-Bills would be the only high-quality paper available. This would also provide the EMU with its so-called riskfree asset as a collateral for transactions with the central bank. It would also offer the ECB the possibility to adopt a more traditional policy of quantitative easing without having to intervene in national markets for government debt should circumstances demand this. The direct link between governments and their national hand. 6 Pension Background September 2012 no 1 7 banking systems would be severed by the introduction of Euro T-Bills. This constitutes a major improvement on the current situation. Note that the ECB’s operations, especially the LTRO, actually caused those ties to become a good deal tighter. The monetary union can be consolidated by the introduction of eurobonds, without more political integration than had been planned already on the basis of the agreed tighter governance of the eurozone. It is debt of the weaker countries would decrease. Therefore it is advisable to extend the maturities in a follow-up programme. Finally, the formula needed to calculate the premiums must be determined, although this also seems to be a minor problem (see Boonstra, 2012). Consequences for investors The introduction of eurobonds along the lines of this proposal will change the investors’ landscape ‘As time goes by and the govern ments in the countries under pressure use the bought time well and implement the right policies, we will see the first real economic results of their efforts.’ not just the weaker countries which will benefit, there are advantages for the stronger states too. Apart from the continuation of the EMU, the above-mentioned self-funding character of the programme is the main advantage. A further benefit for stronger states concerns the expected liquidity premium. This is because the ample liquidity of the market for Euro T-Bills will result in lower interest rates due to these instruments’ greater tradability (ELEC, 2012). Disadvantages There are disadvantages too. Phasing out a member state might cause unrest, although given the crossguarantee on the outstanding debt, the chances of serious contagion are slim. Therefore the bargaining position of transgressor states would de facto be seriously undermined by the introduction of eurobonds. Another disadvantage is that the average maturity of the national 8 considerably. First, the participating countries will have to stop the issuance of short-term debt. The short end of the euro yield curve will only consist of Euro-T-Bills. Only in the longer maturities will national government bonds be traded. One may expect that in the medium (2<x<5 years) maturities yields will converge, owing to the fact that the credit risk of government bonds of the perceived weaker countries will diminish, as they will always have access to liquidity for the duration of the scheme. Bond yields in the weaker countries will come down, yields in the stronger countries will go up. As time goes by and the governments in the countries under pressure use the bought time well and implement the right policies, we will see the first real economic results of their efforts. This will improve confidence and result in a further normalisation of the public bond spreads on the financial markets. The resulting increase of government bond yields in the stronger countries will also lead to an increase in the swap yieldcurve, which will help pension funds to improve their coverage ratios. Conclusion What is the way forward if we decide against introducing eurobonds? In that case, it must be feared that the eurozone will experience much deeper crises over the coming months and years than the current one. The proposed temporary Euro T-Bill programme would give policymakers time to implement good policies and to consider a permanent reform of eurozone governance. The temporary nature of the programme is an important asset, as it will be possible to accumulate some experience with eurobonds as an instrument, which can prove itself in this period. Any desired changes can be included in a follow-up programme. Once the new fund also takes over most of the portfolio of weaker states’ government bonds accumulated by the ECB and places these in the eurobond programme, the central bank will once again be able to focus its energy on its core task: monetary policy with the ultimate goal of combating inflation. After four years, the Euro T-Bill programme could, if desired, be converted into a new temporary, or even a permanent eurobond programme covering all maturities. Should the programme be less successful than hoped for, and should the decision be taken not to extend it, then we may well have lost one illusion, but we would not be in a worse position than we find ourselves in today. References Bishop, G. et al. (ELEC, 2012), The ELEC “Euro T-Bill Fund”, A proposal for a two-year refinancing for all € bills / optional refinancing of bond maturities until 2015, January, http://www.elec-lece.eu/documents/doc/mon12jan-EmuBondFund.pdf Boonstra, W.W. (1989), EMU Fonds: het ei van Columbus?, Economisch Statistische Berichten, 6 December. Boonstra, W.W. (2012), Conditional Euro T-Bills as a transitional regime, Rabobank Special, 2012/05, 13 June. European Commission (EC, 2011), Feasibility of introducing Stability Bonds, draft Green paper, 23 November. Wim Boonstra Chief economist at Rabobank Netherlands, lecturer of Monetary and Banking Systems at VU University, Amsterdam, and President of the Monetary Commission of ELEC, Brussels Pension Background September 2012 no 1 9 The impact on pension funds of a mandatory clearing regime for OTC derivatives On 15 September 2010, two years after the collapse of Lehman Brothers, the European Commission published a draft Regulation for the OTC derivatives markets (Regulation).1 This Regulation is expected to come into force with immediate effect in August 2012, with no additional EU Member States legislation being needed. The Regulation will change the regulatory framework of OTC derivatives and the way OTC derivatives markets operate. The main reforms are: 1. Regulation /supervision of derivatives market participants will be increased. 2. A push will be made towards greater standardisation of derivatives contracts. 3. Mandatory clearing through a central clearing organisation (Central Counterparty-CCP) will be introduced for all OTC derivatives contracts that are determined to be eligible for clearing. All market participants will be obliged to clear OTC derivatives contracts. To eliminate counterparty risks, CCPs will require the posting of collateral in the form of initial and variation margin. 4. Strict rules will be introduced for uncleared derivatives contracts to manage operational and credit risks and higher margin and capital requirements. 5. Reporting of OTC derivatives contracts to a central repository will become mandatory. § The introduction of mandatory clearing is part of a broader package of measures, agreed upon by the G-20 countries, to improve the transparency of the OTC derivatives markets and reduce systemic risk. The G-20 agreed that this standardised regime for clearing OTC derivatives 1 ‘Proposal for the European Parliament and of the Council on derivative transactions, central counterparties and trade repositories’, <register.consilium.europa.eu>. See also: B.J.A. Zebregs, ‘Verplichte clearing voor OTC-derivaten in Europa’, Tijdschrift voor Financieel Recht, 2011-1/2, p. 5-17. must be implemented in 2012 at the1 latest.2 Similar legislation is therefore in preparation in other jurisdictions including the US, Japan, Australia, Hong Kong, Singapore and Canada. Although coming into force in August 2012, the Regulation will not yet be fully enforceable. Current expectations are that the mandatory clearing regime will not become effective until mid-2013. This mandatory clearing regime will have a huge impact on the OTC derivatives markets and market parties. For clearing members, the parties through which a CCP is accessible, the regime involves specific risks and costs. Similarly, the clients of clearing members will also incur additional risks and costs, especially the more creditworthy clients who have one-way derivative exposure due to using derivatives as hedging instruments. Below, we will highlight some important elements of a mandatory clearing system from a pension fund perspective.. Do CCPs reduce systemic risk? CCPs take over the counterparty risk inherent in OTC derivative contracts (see Figure 1), and thus potentially reduce systemic risk. As long as the CCP is able to absorb the bankruptcy of one or more of its clearing members, this can prevent a domino effect of additional bank ruptcies. If the CCP itself were to go bankrupt, however, given the concentration of risks within such an institu tion, the effect could be dramatic. CCPs will be the 2www.pittsburghsummit.gov Pension Background September 2012 no 1 11 Figure 1: Clearing members and novation Change and impact Figure 2: Bilateral and multilateral netting (amounts in EUR m) Buy Side ‘End’ User Multilateral netting Bilateral netting Sell Side ‘End’ User 20 A B 50 Clearing Member CCP Clearing Member Sell Side ‘End’ User OTC derivatives transactions are agreed bilaterally between the two market participants. In a clearing structure, however, the final transactions are not established between the market participants (end users) who initiated the transaction, but between a limited number of clearing members and a Central Counterparty (CCP). Market participants who do not have the status of clearing member must therefore establish a clearing relationship with a clearing member, in which they authorise the clearing member to conclude transactions on their behalf (client clearing). Under the terms of novation, the transactions between two clearing members are split into two, as it were, with the CCP interposed. There is a transaction (1) between the clearing member of client A and the CCP, and (2 between the CCP and the clearing member of client B. The counterparty risk between clearing members is taken over by the CCP. ultimate too big to fail institutions. The question is, how likely is this to happen? The large amounts of collateral that are required to be posted with a CCP mean that the risk of a CCP going bankrupt is small. However, it is not inconceivable, and in this case a CCP could also become too big to save. In view of the inherent concentration risks, it is incomprehensible that under the new regulations these infrastructural CCPs will operate as commercial organisations. The same applies, to a lesser extent, for clearing members. They perform infrastructural tasks and should not have been permitted to combine their clearing activities with that of proprietary trading. A CCP potentially provides netting benefits, as the positions of its clearing members are set against each other to reduce the counterparty risk (multilateral netting, see Figure 2, page 13). These benefits cannot be achieved, however, if the market is fragmented, which it will be in the clearing system as 12 envisaged by the Regulation. Market fragmentation can only be avoided if (1) there is only one CCP, (2) everyone uses the same clearing member and (3) all OTC derivatives contracts are cleared. In practice, however, none of these conditions will be met. First of all, there will be various competing CCPs. In current European practice, SwapClear is dominant in the clearing of inter est rate swaps, whereas ICE is the undisputed market leader for the clearing of credit default swaps. Secondly, many parties do not want to be dependent on a single clearing member, not only for commercial reasons, but also to ensure that positions can be transferred at short notice to a back-up clearing member in the case of default of one of its clearing members (portability). Finally, far from all OTC derivatives are sufficiently standardised, liquid, and suitable for automatical pricing to qualify for clearing. This means that, in addition to centrally cleared transactions, bilateral uncleared transactions will continue to exist. Significant netting benefits may thus be lost, and counterparty risk could become even greater (see Figure 3, page 14). C D 30 60 B B 5 10 15 Buy Side ‘End’ User A C 20 50 D 55 Counterparty risk: Counterparty risk: A = 70, B = 5, C = 70, D = 10 A = 60, B = 0, C = 20, D = 0 With bilateral netting, the mutual obligations of counterparties are netted to a single payment obligation. This corresponds with the current situation under ISDA contracts. Multilateral netting is possible if a CCP operates as a central counterparty. The bilateral derivative contracts between Parties A to D are replaced by contracts between Parties A to D with the central clearing organisation. This results in netting not only of contracts between each of the counterparties themselves, but also of the obligations across the counterparties as a whole. As a consequence, the counterparty risk for Parties B and D becomes zero, and the counterparty risk for Parties A and C is reduced. In this graph we assume that the Parties A to D all have the status of clearing members. However this will not be the case for most market parties. Suppose that Party A is not a clearing member and uses Party C as its clearing member, then Party C will receive a total of EUR 80m(20 + 60). Then Party A will receive an amount of EUR 60m on the basis of the clearing contract with C. Given that there will be some measure of market fragmentation, it is highly questionable whether the potential netting benefits provided by CCPs will be realised in the clearing system as envisaged by the EU regulators. An important advantage of a structure with CCPs compared to the bilateral, uncleared structure is that the valuation method of the CCP will take precedence. This will lead to fewer disputes concerning valuations of positions and the corresponding amount of collateral to be exchanged. The Regulation will have a huge impact on pension funds. Pension funds make extensive use of OTC derivatives to meet obligations arising out of pension plans. To minimise volatility between assets and liabil ities and to offer regulatory protection for pension beneficiaries, they hedge their liabilities against inflation, currency and interest rate risks by means of OTC deri vatives. In general, pension fund investment strategies create “one-way” OTC derivatives exposure, especially in long-term interest rate swaps. A CCP is exposed to counterparty risk during the lifetime of an OTC derivatives transaction. Depending on the amount and type of open derivative positions, the CCP’s counterparties, the clearing members, must maintain collateral with the CCP. The clearing members in their turn require collateral from their clients. In a CCP structure, much more collateral will be provided than in the current bilateral structure. Not only is collateral exchanged for the current counterparty exposure (varia tion margin), but also additional margin must be deposited to protect the CCP against potential counter party exposure (initial margin). Although not prescribed by the Regulation, at present CCPs only accept cash as eligible collateral for variation margin. Cash collateral provides the most security and is operationally the easiest to process. Under the current non-cleared structure, both cash and securities are considered eligible collateral. Many asset managers and pension funds prefer to have the option to post securities as well. A requirement to accept cash only for variation margin purposes could lead to liquidity problems. After all, if a client has no cash available, it must generate cash either by borrowing cash or selling assets. The 2008 crisis has taught us that the impact of liquidity problems should not be underestimated. It is anticipated that many clearing members will offer financing and collateral transformation services. We expect strong growth in the market for repurchase agreements (repos), which by definition will increase counterparty risk. Given the low levels of interest earned on cash collateral and the maintenance of cash buffers, combined with the fact that Pension Background September 2012 no 1 13 Figure 3: Market fragmentation – Bilateral versus centrally cleared Bilateral netting leads to net exposure of EUR 3m. Inflation Swap ISDA/CSQ +5mln +3 mln Net. exposure Interest Swap ISDA/CSQ +5mln Inflation Swap ISDA/CSQ +5mln +5 mln Net. exposure Interest Swap ISDA/CSQ +5mln If bilateral ILS and centrally cleared IRS cannotbe netted,exposure is +EUR 5m. this cash cannot be invested otherwise (opportunity loss), the costs of cash collateral can be very substantial. Temporary exemption for pension funds For pension funds, with their large one-way OTC derivatives positions, the requirement to post (cash) collateral in a clearing system would mean having to provide massive amounts of margin. Given that pension funds aim to be fully invested and their portfolios are very heavy on government bonds and very light on cash, the EU institutions decided that pension funds and their dedicated investment vehicles should be exempted temporarily from mandatory clearing. This would give the CCPs time to adjust for the acceptance of non-cash financial instruments for variation margin purposes. Following a successful lobby by APG and the Dutch Pension Federation, pension funds and their dedicated investment vehicles are exempted from the mandatory 14 The more standardised and liquid derivatives contracts, such as many interest rate swaps and credit default swaps, are relatively easy to clear. CCPs are already active for these products. For other derivative contracts, such as inflation-linked swaps and swaptions, this is not (yet) the case. Although CCPs will try to broaden their product offerings, a significant percentage of derivative contracts will remain unsuitable for clearing. If only some derivative transactions are cleared centrally while others are traded through bilateral CSAs, the market will be fragmented. Operationally, this means that collateral must be exchanged both bilaterally and with clearing members. In addition, netting benefits will be lost and counterparty risk could increase. This is made clear in the following example, in which a market participant can net its exposure from inflationlinked swaps (ILS) against its exposure from interest rate swaps (IRS) in a bilateral structure, whereas this is not possible if only IRS transactions are cleared centrally. clearing requirement for a period of three years, with the possibility to extend this period for another two years, and finally for one more year. Meanwhile pension funds have the option to start clearing voluntarily or to continue the current bilateral structure until the exemption expires. The Regulation will also establish more stringent requirements for OTC derivatives transactions that do not (yet) qualify for mandatory clearing or that are exempted. This includes the requirement to exchange collateral on a daily basis for the outstanding obligations, comparable with variation margin. In itself, this is a good idea. However, a daily exchange of collateral can be problematic and costly for market participants, especially smaller ones. The so-called level two rules to be adopted by the European Commission will also require initial margin to be posted for uncleared derivatives contracts. The aim of this requirement is to encourage clearing. In the current uncleared structure, pension funds do not need to post initial margin because of their creditworthiness. Although the level two rules under the Regulation still have to be drafted and adopted, it is likely that pension funds and their dedicated investment vehicles will be obliged in future to exchange or post initial margin for their uncleared transactions. This could have a considerable impact on pension funds. In our opinion, this measure punishes the wrong parties. The creditworthiness of pension funds and their dedicated investment vehicles needs to be taken into account in the initial margin calculation. Effectively they should be required to post a smaller amount of initial margin than more leveraged/risky entities, or none at all. It is important that the initial margin requirements do not undermine the value of the exemption by discouraging the use of uncleared derivatives contracts. Mandatory clearing requires pension funds to use clearing members in the future.3It is expected that a relatively small group of CCPs and clearing members will dominate the clearing market. The danger of this scenario is that, in comparison with the current scenario featuring bilateral ISDA contracts, there will be little room for negotiation and high fees will be charged to pension funds.4 The fees charged by clearing members and CCPs, the requirement to deposit collateral partly in cash, and the possible requirement to generate liquidity on short notice will increase the costs for pension funds significantly. They will then have several options: •Continuing the use of OTC derivatives with the higher costs and therefore accepting lower performance. Other investments could be divested to generate cash (collateral). Then they 3 The International Swaps and Derivatives Association has developed standardised Master Agreements that can be declared as applicable to all OTC derivatives transactions concluded between parties. Usually collateral is exchanged regularly on the basis of a supplementary Credit Support Annex, <www.isda.org>. 4 For example, SwapClear, the European market leader for the clearing of interest rate swaps, pays EONIA minus 30bp on cash collateral. could attempt to replicate the risk profile of the reduced investments with OTC derivatives. This would therefore lead to an increased use of OTC derivatives, and higher collateral requirements. •Reducing the use of OTC derivatives, for example by accepting more risks rather than hedging these risks, or by using other hedging strategies that are not as good and can result in a greater mismatch. Bankruptcy of the clearing member If a clearing member goes into default, the CCP holds the positions of the defaulted clearing member on its own book. The CCP will first try to transfer the positions of the defaulted clearing member, including the outstanding initial and other margins, to another clearing member (portability). The Regulation provides for this in the appointment of back-up clearing members, but they will stipulate conditions to enable refusal. The absence of a system of guaranteed portability is a serious shortcoming. The Regulation also says nothing about portability when a CCP goes bankrupt. Finally, we note that parties must be able to act swiftly in chaotic situations. For example, SwapClear has a procedure by which transfers must be made within 48 hours, other wise all positions are liquidated, with all the replacement risks that this entails. Another shortcoming is that in some cases, for instance with SwapClear, securities collateral is immediately liquidated upon a default. Asset segregation is essential when a clearing member goes bankrupt. In this context, it is important whether collateral is held in a segregated client account or a joint omnibus account. Segregated accounts offer more protection, but less netting opportunities. Omnibus accounts offer more netting options, but if there is a deficit, the CCP recovers this deficit from the collateral deposited by the joint clients. This means that a client is exposed to risks caused by third parties. Pension funds should be aware of this. At present there is a wide variety of segregation models available or under development, each of which needs to be carefully examined. We believe that the provision of initial margin should also be made possible by means of guarantees or Pension Background September 2012 no 1 15 pledges. This would soften the blow for many financial institutions, because the number of settlements (and with that the transit risk) could be reduced and the CCP would only obtain access to the margin assets in the actual event of a default. Nicole Grootveld COO NL Cardano Transaction reporting OTC derivatives transactions should be reported as soon as possible to a central repository (trade repository). If transactions are cleared centrally, the CCP or the clearing member will report them. However, uncleared transactions must also be reported and, depending on the degree of detail required and the reporting deadline, this can be an operational challenge. Reporting can be outsourced, but this has to be agreed with each counterparty. The transaction details can be used by supervisory bodies. Any disclosure to the market, however, should take account of the commercial sensitivities of this information. This problem can be solved by disclosing this information only after a mandatory waiting period and on an aggregated basis. Conclusion Zöhre Tali APG Asset Management Bas Zebregs APG Asset Management The Regulation will soon come into force, but many loose ends remain to be dealt with in more detailed level two rules. Meanwhile, the industry is preparing as well. SwapClear and ICE can expect competition from CME Europe and Eurex. It seems however that the risks and costs that centralised clearing entails are still underestimated by many market participants and supervisory bodies. Also, it is becoming increasingly clear that although systemic risk may be reduced with the introduction of CCPs, for individual users it could mean that they must actually accept greater risks and costs. Their involvement in the rulemaking process of the level two rules is essential to limit the negative impact on their business. 16 Pension Background September 2012 no 1 17 The European Pension Agenda The recent debate on the Dutch pension system, pension agreements, pension fund governance and discount rates may seem to be primarily a national debate, but Brussels may have quite a significant influence on Dutch pensions too. This article looks at the European Commission’s latest policy initiatives regarding pensions and their impact on the Dutch pension system. The European Treaty and the European Six-Pack governance structure authorise the European Commission to give instructions to all member states to improve their national economies and public finances1. This implies that the Commission can also make recommendations regarding pensions. A good example is the recent advice of the Commission to the Netherlands, and also to the national governments of other member states, to raise the retirement age and to link this to the national life expectancy rates2. In addition to this advisory competence, the Commission has an important role in the coordination of pension policy across member states. The final responsibility for pension policy, however, is primarily with the individual member states. The European Commission’s most important policy initiatives regarding pensions in recent months have been the publication of the White Paper on Pensions and plans to revise the IORP Directive. White Paper on Pensions The publication of the European Commission’s White Paper on Pensions3 is the most recent step in a new 1 European Commission (2011), EU Economic Governance “Six-pack” Brusseectiels, December. 2 European Commission (2012), Council Recommendation on the Netherlands’ 2012 national reform programme and delivering a Council opinion on the Netherlands’ stability programme for 20122015, Brussels, 30 May. 3 European Commission (2012), White Paper An Agenda for Adequate, Safe and Sustainable Pensions for Europe, COM (2012) 55, , Brussels, 16 February. policy process on pensions. The process started in 2010 with a Green Paper on Pensions4 . The idea of this Green Paper, applying a so-called holistic approach to many pension-related issues, was to get a European debate going on the (fiscal) sustainability of public pensions in the member states and the adequacy of pension provision for European citizens. The second step in this process was a statement by the Commission in 2011 summarising the main conclusions from consultation on the Green Paper5. In the White Paper on Pensions, the European Commission puts forward twenty initiatives which could promote the security, adequacy and sustainability of the pension provision for European citizens. These initiatives are based on the Commission’s conclusion that accelerated ageing of the population has become a severe threat to future growth in the EU and will, even without factoring in the consequences of the current financial and economic crisis, lead to heavy pressure on the public finances of the EU member states. In the Commission’s view, reforms of the national pension systems are therefore a matter of utmost urgency, particularly in those member states where retirees still depend largely on pay-as-you-go first pillar government pension schemes for their income. 4 European Commission (2010), Green Paper Towards adequate, sustainable and safe European pension systems, Brussels, 7 July. 5 European Commission (2011), Summary of consultation responses to the Green Paper “Towards adequate, sustainable and safe European pension systems”, Brussels, 7 March. Pension Background September 2012 no 1 19 and expenditures till 2060 Reduction first pillar pension till 2060 (compared to 2010) Increase expenditure first pillar pension till 2060 (% GDP) Going forward, these first pillar public pension schemes based on pay-as-you-go financing will come under increasing pressure. In the EU, the so-called dependency ratio will double from 26% in 2010 to 53% in 2060: the number of persons of working age (15-64 years) per retiree (65 +) will decrease from four to two6. Meanwhile, the sovereign debt crisis is causing further pressure on pensions. Since the mid-1990s, therefore, many countries have been drastically cutting back their 6 European Commission (2009). 2009 Ageing Report: Economic and budgetary projections for the EU-27 Member States (2008-2060), European Economy 2, April 2009, Brussels. 20 Given the large variation in pension systems from member state to member state, the Commission emphasises that the responsibility for pension policy should be primarily with the member states, and that its own role will be mainly a facilitating one. As a consequence, most of the Commission’s twenty initiatives are not proposals for new European regulation, but recommendations to national member states. Box 1 summarises the initiatives proposed by the European Commission. The policy initiatives to improve the balance between time spent in work and retirement will have a positive effect on national budgets and the entire economy. As such, they are likely to benefit the Dutch pension sector. As for the initiatives to improve and develop complementary pension savings, the European Commission concludes that supplementary funded pensions will have to play an increasingly important role in the future pension provision and should therefore be encouraged. The Commission furthermore argues 140 120 100 80 60 40 20 0 ce ee Gr ce rg an ou Fr mb xe Lu nia ve Slo ium lg Be ly y Ita an rm ic Ge ria ubl st ep Au h R ec Cz k va Slo n ai Sp en ed l Sw ga rtu Po gary n Hu nd la Po nd la k Ire ar nm De d lan Fin nd UK zerla it Sw nd s la nd Ice erla th Source: Europese Commission, The 2012 Ageing Report: Economic and budgetary projections for the EU-27 Member States (2008-2060), European Economy 2, April 2012, Brussels One of the reasons for these differences is the current starting position. In some EU member states, total pension income is almost completely dependent on public pensions, which are pay-as-you-go financed (first pillar). In some other member states, like the Scandinavian countries, the UK and the Netherlands, total pension income is to a substantial degree dependent on funded pension arrangements (second and third pillar). Figure 2 shows an overview of the pension savings in different member states. Compared to other member states, people in the Netherlands save a lot for their retirement. Figure 2: Assets in pension funds 2010 (%GDP) Ne Belgium-5,60% Bulgaria-6,00% 1,10% Cyprus18,00% 8,70% Denmark-0,60%-0,60% Germany-13,00% 2,60% Estonia-16,00%-1,10% Finland-16,00% 3,20% France-10,00% 0,50% Greece-43,00% 1,00% Hungary6,00% 2,80% Ireland2,00%4,10% Italy-14,00%-0,90% Latvia-68,00%-3,80% Lithuania-6,00% 3,50% Luxembourg-26,00% 9,40% Malta-13,00%5,50% The Netherlands- 3,60% Norway-23,00% 4,90% Austria-22,00% 2,00% Poland-62,00%-2,20% Portugal-13,00% 0,20% Slovenia-7,10% Slovakia-42,00% 5,20% Spain-23,00%3,60% Czech Republic-5,00% 2,70% United Kingdom 35,00% 1,50% Sweden-36,00% 0,60% traditionally generous pension schemes. As a result of the various austerity measures, pension benefits as a percentage of wage will, on average, be 20% lower in 2060. Despite these austerity measures, average expenditure on first pillar pensions will continue to climb. Figure 1 shows that the differences between the EU member states are considerable, in terms of both the austerity measures affecting the first pillar pensions and growth of expenditure on these pensions. Pension Funds Assets (%GDP 2010) Figure 1: Developments public pensions Source: OECD 2012 Statistics that already existing supplementary pension systems could be improved in some member states. In the Commission’s view, supplementary pensions need to be made more secure, cost-efficient and tailored in order to achieve a more flexible labour market in the EU. Tax incentives and agreements between social partners (employers and employees) can play an important role in this respect, the Commission believes. She therefore Box 1: Main initiatives proposed in European Commission’s White Paper on Pensions A.Balance time spent in work and retirement, for example: - Link the retirement age to life expectancy - Abolish early retirement schemes and other early labour market exit options - Equalise retirement ages for men and women where this has not already been done B. Develop complementary private C. Enhance the EU’s monitoring savings, for example tools on pensions and strengthen - Support initiatives in member states to synergies across policy areas, develop supplementary pension schemes for example: - Develop a code of good practices for occu- - Prepare the 2012 Ageing Report pational pension schemes (second pillar) assessing the economic and budgetary - Review good practices with regard to impact of ageing, which will form individual pension statements, with the the basis for a thorough assessment aim of encouraging member states to of the sustainability of public provide better information to individufinances (envisaged for release in the als for their retirement planning Commission’s 2012 Sustainability - Improve cross-border pension mobility Report) for all occupations (To this end, the European Commission must resume work on a pension portability directive setting Europe-wide minimum standards for the acquisition and preservation of supplementary pension rights) - Review the IORP Directive Pension Background September 2012 no 1 21 Figure 3: Participation in supplementary pension schemes, % of current employees 100 80 % workers 60 40 20 0 l ga rg rtu ou Po mb xe Lu ain Sp and l Fin tria s Au ce an Fr y l Ita 27 EU and l Ire rus a p i Cy an hu ia Lit an m Ro UK nia to a Es gari l Bu ium lg a Be eni v ry Slo ga y n n Hu a rm a Ge aki v Slo d lan rk Po ma n De ia ds tv lan La her t Ne den e Sw Source: EFRP, Workplace pensions – Defined Contribution, Survey, March 2010, Brussels or The Social Protection Committee, Privately managed funded pension provision and their contribution to adequate and sustainable pensions, 2008, Brussels aims to develop a code of good practices for occupational pension schemes (second pillar), addressing issues such as better coverage of employees, the payout phase, risksharing and mitigation, cost-effectiveness and shock absorption. Especially with respect to the coverage of employees, there is a lot of room for improvement, given how many employees are still not entitled to a supplementary pension. At present, only 40% of employees in Europe participate in occupational pension schemes or individual pension plans made mandatory by the government (see Figure 3). Furthermore, the Commission will investigate whether national level tax rules on cross-border transfers of occupational pension capital and cross-border investment returns of pension providers present discriminatory obstacles. If necessary, infringement procedures will be initiated against member states imposing such tax obstacles. In resuming work on a Pension Portability Directive, the Commission can help 22 set Europe-wide minimum standards for the acquisition and preservation of supplementary pension rights. Measures like (1) reducing vesting periods (which imply that employees only acquire pension rights after having spent a minimum number of years in a job, e.g. five years), (2) guaranteeing equal treatment of pensioners and sleepers (e.g. when granting indexation) and (3) promoting pension tracking services will certainly also promote cross-border mobility of European employees. On the other hand, cross-border portability/ transferability of the acquired pension rights of such employees (as earlier proposed by the Commission) would lead to many technical and budgetary complexities. This is not necessary to achieve cross-border mobility, might hamper well-functioning existing pension systems and should therefore not be proposed again. Revision of the IORP Directive Another policy initiative by the European Commission that could change the pension landscape is the planned revision of the IORP Directive.This is a major concern for the Dutch pension sector, as it could hamper pension provision across Europe. Occupational pensions are regulated at EU level by the Institution for Occupational Retirement Provision (IORP) Directive, which was introduced in 2003. The objective of the IORP Directive is to provide a regulatory framework for occupational pension funds across Europe. In 2011, the Commission initiated a debate on potential adjustments to the IORP Directive by submitting a Call for Advice to the European Insurance and Occupational Pensions Authority (EIOPA) 7. The ultimate aims are: •To simplify the legal, regulatory and administrative requirements for setting up cross-border pension schemes •To introduce risk-based supervision •To modernise prudential regulation for pension funds that operate DC schemes, given the increasing number of DC schemes across Europe Figure 4: Impact of applying Solvency II on value liabilities and capital requirements FTK Solvency II Assets (bn €) 775 775 Liabilities (bn €) 662 738 Initial coverage ratio 117% 105% Required coverage ratio 117% 126% 0 155 SCR shortfall (bn €) Source: De Haan, Jurre, Agnes Joseph, Siert Vos and JanWillem Wijckmans (2012), De impact van Solvency II op pensioenfondsen, ESB 4629, February 2012 more stringent than the current FTK rules. Applying Solvency II to Dutch pension funds means that they will be confronted with a higher required level of assets (see Figure 4). The impact of applying Solvency II to pension ‘The capital requirements out of Solvency II aim to provide a high level of security on the short run and are more stringent than the current FTK rules.’ The Call for Advice covers a broad range of topics, like the scope of the IORP Directive and transparency and governance requirements. A controversial question put forward in the Call for Advice is whether some of the quantitative requirements from the Solvency II Directive for insurance companies could be incorporated into a revised IORP Directive. For European pension funds, this is a point of concern. The capital requirements out of Solvency II aim to provide a high level of security on the short run and are 7 European Commission (2011), Call for Advice from EIOPA for the review of Directive 2003/41/EC (IORP II), Brussels, 30 March. funds in other member states with large IORPs, such as Germany, Ireland and the UK, will be even greater. Increasing the level of assets to the required minimum could be achieved by adding to the asset side (higher contribution rates and additional sponsor support) and/or by subtracting from the liability side (reducing pension benefits). The latter option seems more likely, as under current circumstances it is questionable whether employers and employees will be able to finance the shortfall. Another possibility for a pension fund could be a de-risking of the asset mix. A more conservative asset mix implies lower capital requirements in the short run. Pension Background September 2012 no 1 23 However, in the long run this means lower expected investment returns and consequently lower pension benefits. Even though EIOPA – as well as the European Commission – has emphasised on several occasions that the Solvency II requirements will not be copy-pasted into the revised IORP Directive, and that the unique Figure 5: Traditional vs holistic balance sheet Traditional balance sheet Assets Holistic balance sheet Liabilities Assets Sponsor Support Surplus Assets Assets Technical provisions Liabilities Surplus Increasing conditional liabilities Technical provisions Lowering conditional liabilities Directive proposal before the summer of 201310. The concerns with respect to the quantitative requirem ents do not mean that other recommendations in the response to the Call for Advice will not contribute to the improvement of second pillar pensions across Europe. The recommendations with respect to governance of pen sion funds, the embedding of good risk management and clear and understandable transparency requirements will certainly be helpful in this respect. Conclusion On the one hand, initiatives from Brussels could be bene ficial for the Dutch pension system. European steps to create more stability and to improve national budgets as well as the entire European economy will have a positive impact on the return of pension funds, especially in the long run. Besides, pension systems in many EU mem ber states are highly dependent on the government and public finances. These pay-as-you-go financed pension systems are very vulnerable to the ageing of the popula tion. Spiralling national government budget deficits put the public pension provision under even more pressure. Its advice to the European Commission8, EIOPA responded that some of the (quantitative) requirements in Solvency II can theoretically be applied to pension funds, but that the revised directive should take account of certain unique characteristics of pension funds that distinguish them from insurance companies. EIOPA therefore proposes the so-called Holistic Balance Sheet approach. As shown in Figure 5, the Holistic Balance Sheet enables pension funds to assess and attribute a value to the steering mechanisms (sponsor support, increasing contributions) and adjustment mechanisms (conditional indexation, cutting pension rights) that they use. As it makes the differences between insurance companies and pension funds explicit, the Holistic Balance Sheet approach can be seen as intellectually tempting. However, as it constitutes a whole new way of supervision and is quite complex, EIOPA suggests first investigating the impact of this new method. Pension funds in different member states will be asked to perform Quantitative Impact Studies. characteristics of pension funds should be taken into account, the revision of the IORP Directive continues to be a major point of concern for the pension sector. The threat of quantitative requirements based on Solvency II provides a strong incentive for pension funds to focus on providing a high level of security in the short term instead of delivering adequate pensions in the long run. Meanwhile, the draft Technical Specifications for the Quantitative Impact Study9 show that the proposed Holistic Balance Sheet approach is not only highly complex, but above all very dependent on subjective assumptions, making it very sensitive to model risk. The draft Technical Specifications of the upcoming Quanitative Impact Study also shows that some fun damental issues with respect to the valuation of the steering and adjustment mechanisms are not clear. This means that the Quantitive Impact Study will certainly not provide answers to all the relevant questions nee ded to rewrite the IORP Directive. Nevertheless, the Commission intends to use the output of the QIS for a If deficits are not addressed, there is a severe risk that the public finances of the relevant member states will eventually prove to be unsustainable. This risk might tempt these member states to “shrink” their pension liabilities by increasing inflation. This would be to the detriment of the pension capital which has been built up in the Netherlands. We welcome the European Commission’s acknowledgement of the importance of properly functioning complementary pension provision across Europe, as well as the Commission’s intention to improve regulation for governance, information and transparency in the pension sector. These proposals could contribute to the creation of more occupational pension schemes in the EU and to the key goal of achieving pension security for EU citizens. On the other hand, European initiatives could entail risk for the Dutch pension sector. New EU regulations could lead to an unnecessary increase of costs and administrative charges and consequently to lower pension benefits for participants. Because the Dutch 8 EIOPA (2012), Response to the Call for Advice on the review of 9 10 EFRP (2012) , Response to EIOPA Consultation on Quantitative Directive 2003/41/EC: Second consultation Frankfurt, 15 February. 24 EIOPA (2012), Draft Technical Specifications for the QIS of EIOPA’s Advice on the Review of the IORP Directive, Frankfurt, June. pension system is quite unique in Europe, there is a danger that new European regulation will not sufficiently take into account its specific characteristics. The review of the IORP Directive could be considered a case in point. It is causing grave concern in the Netherlands, both at government level and in the pension sector and with politicians (see also the article by Pieter Omtzigt in this Pension Background). With respect to current proposals for the revision of the IORP Directive, we are not convinced that these will lead to a better pension provision in the EU going forward. Future developments with regard to these proposals therefore need to be carefully monitored by the Dutch pension sector and government. Jurre de Haan Corporate Strategy and Policy APG Wilfried Mulder Corporate Strategy and Policy APG Impact Study (QIS), Brussels, July. Pension Background September 2012 no 1 25 IORP: Some chances and challenges ahead The European Commission’s recent White Paper on pension systems contains a number of interesting proposals. As it is in the interest of all EU countries that each country has its pension system in order, the Commission is justified in taking initiatives. However, Dutch Parliament has objected to two proposals: those regarding a new IORP-directive and the portability of pension rights in a new portability directive. As under the Lisbon treaty parliaments can issue a yellow or an orange card if they feel that the Commission’s proposals are in conflict with subsidiarity, Dutch parliament has appointed Pieter Omtzigt as rapporteur on this White Paper with the aim of convincing the European Commission and other parliaments that these two proposals should be withdrawn or heavily modified. Introduction Currently, one of the greatest political challenges for Europe is ensuring the sustainability of pension systems that have come under increasing pressure due to an ageing population and the current economic crisis. Recent initiatives taken by the European Commission, for example in drawing up a White Paper on sustainable and adequate pensions, are therefore more than welcome. The Netherlands also attaches a great deal of importance to a sustainable and adequate pension system that has the capacity to deliver a decent income for pensioners in the future (for which in the Netherlands they make their contributions during their active working period). In view of the demographic challenges and the current upheaval in the financial markets, it will be necessary to monitor the European pension systems closely. Given the wide diversity of systems and unique national regulations across Europe, it will remain a major challenge to find common ground within Europe to deal with these problems without infringing on existing rights of current and future pensioners. In this respect it can be considered a material and legally enshrined fact that the principal authority to develop and formalise pension systems rests with the member states and not with the European Union. We have noticed that the creation of large pan-European financial institutions in the banking and the insurance sector has caused major problems. Large banks need to be rescued because their failure would jeopardise the proper functioning of the economic system, as we have seen during the current crisis. It is wise to exercise caution in the process of aiming for large European pension funds, large financial entities. Nevertheless, it is useful to talk about common baselines, such as linking the pension age to the life expectancy rate, better access to second-pillar pensions and better provision of information. Affordable and adequate pensions are important for everyone. Secondpillar pensions can be of great value in this regard. Consequently, promotion of these pensions should not be hampered by disproportionally strict rules from Europe. This could certainly be the case where pension systems are already well developed. It is therefore of vital importance that decisions on these systems remain the domain of member states. This also ensures that Pension Background September 2012 no 1 27 countries are and remain responsible for financial problems within their own systems. The Dutch system is a mixture of financial and social components, which allocates responsibilities to the government, the social partners and individual employers and employees. Central to this system is the principle of solidarity. Most proposals in the White Paper look appropriate at first sight. It is wise to assess the sustainability of the labour market and the pensions system given the major demographic changes now taking place. The proposal to preserve the entitlements of employees who have worked in different countries for a number of years is also prudent. These employees must be able to collect their pensions in a straightforward manner by means of a tracking service, and they must have access to good information. Furthermore the waiting and vesting periods must not be excessively long, precisely in order to protect them. The intended exchange of best practices between member states can also be extremely helpful, and it is gratifying that the European Commission has emphasised the importance of supplementary pensions and the role of social partners and collective systems Having said all this, there are some issues on which I have a more critical stance . My view is that in order to ensure that the unique aspects of pension funds are protected, the subsidiarity and proportionality principles as described in EU-law should be applied carefully. Let me first explain these principles. Subsidiarity and proportionality principles The Lisbon Treaty and the options of the subsidiarity and proportionality control mechanisms have placed an important instrument in the hands of the national parliaments to help them play their role in European decision-making . The principle of subsidiarity ensures that the European Union does not act in areas which are better regulated at national level. Proportionality is the principle that the form and content of the Union’s actions should not exceed that which is necessary to achieve the Union’s objectives. In a number of proposals discussed in the White Paper on pensions, both elements are manifestly at issue. 28 The subsidiarity check can be applied to all concrete legislative proposals. This procedure can result in a yellow card if one third of national parliaments object to a proposal on the grounds of subsidiarity. The European Commission will then reconsider its proposal. The procedure can lead to an orange card if half of the national parliaments judge that the proposal conflicts with the principle of subsidiarity. If the Council of Ministers or the European Parliament shares this judgement of the national parliaments, then such a proposal will definitely be scrapped. The principles of subsidiarity and proportionality have a very clear relevance here: the design of the national pension system will be put in jeopardy, while it is in employees’ interest that agreements, schemes and supervision are as specific as possible. Harmonisation is in any event nearly impossible due to the entirely different tax systems and differing relationships between first pillar and second-pillar pensions. Pension funds are not insurance companies In the White Paper, the European Commission has announced a legislative proposal for the revision of the IORP-Directive in order to improve cross-border activities, modernise supervision and maintain a level playing field between pension funds and insurance companies, which are covered by the Solvency I IDirective. In my opinion there is no convincing case for such a level playing field for social security schemes (not products) with substantially different characteristics: pension funds operate on a non-profit basis with a col lective sharing of risk, whereas for insurers the capital adequacy of individual policies is primary. Consumer protection is of paramount concern here. For pension funds the primary issues alongside the protection of the participants are fair allocation of risk and inter generational solidarity. As a consequence, insurance products cannot be compared to supplementary pensions. The costs of pension schemes operated by pension funds will not fall, but could rise explosively as a result of demands in a revised IORP Directive for excessive guarantees at the level of insurance companies. This collides with the European Commission’s objective of facilitating more cost-efficient second-pillar pensions. The costs of strict and highly complex quantitative regulations may well be disproportionate, and would deny employees the opportunity to accrue an adequate pension at the lowest possible costs. Legislation setting down complex and detailed prescriptions for the supervision on and setting up of such systems will not contribute to the goal of improving access to second pillar systems. The perverse effect may in fact be a shift to pay-as-you-go (PAYG) schemes, which are not regulated at all. Such a shift has unfortunately already taken place in certain EU member states. delegated to the supervisory authority. In addition, such a supervisory authority would inevitably claim substantial policy freedom with regard to all the national pension systems existing in the EU. This is undesirable. Portability Directive The Commission has announced its intention to put forward a proposal for a Portability Directive on supplementary pensions, with the aim of removing impediments to mobility of labour. This proposal will aim at enabling employees to take their accrued pension rights with them when moving from one country to another. ‘It is gratifying that the European Commission has emphasised the importance of supplementary pensions and the role of social partners and collective systems.’ In these member states pension funds have been nationalised and the national governments have taken over future pension liabilities. This is not in the interest of sustainable government finance in the long term. Increasing European supervision may also result in incremental increases in European responsibilities and obligations. In my view, it is appropriate for the countries themselves to be and to remain responsible for their own pension systems. The question is whether current national and European supervision is actually falling short. Increased European supervision would also mean that essential political choices about such matters as the confidence level of pension benefits would be The topic of portability was last on the agenda of the Council for Employment and Social Policy on 9 June 2008. At that time, no agreement was reached on the proposal and the subject has not come up for discussion since. The Commission’s (revised) proposal aims to promote mobility within national labour markets and between member states. It includes the following elements: 1. substantial measures relating to the acquisition of pension rights (maximum waiting and vesting periods and vesting age), 2. measures relating to their retention (adaptation of sleepers’ entitlements in accordance with the agreed pension is “fair”), Pension Background September 2012 no 1 29 3. a right of information for active and sleeping participants, and 4. an effective date of application two years after the adoption of the directive, with a possibility of a five-year postponement. lower than those that a Spanish fund needs to hold. But if this Latvian fund transfers the entire reserved amount, the “receiving” Spanish fund will still have far too little to satisfy the Spanish accountancy rules because these are based on the Spanish national life expectancy tables. ‘The Netherlands with its pensions register provides an excellent example which can serve as a blueprint for a European solution.’ Due to various technical issues, portability would under this directive run into insurmountable problems: a. Some countries levy tax on contributions, whereas other countries levy tax on pension payments. In order to take into account these differences in tax treatment, a recalculation would be required in the case of cross-border transfer of pension rights. An additional complication in this respect could be the possibility that a member state would need to pay back tax already levied after an employee has left this state. b. Portability can only apply if the accrued pension entitlements are fully funded. This is only the case on a large scale in a few countries. Capital can only be transferred from those countries. Pension systems in EU member states vary from PAYG systems via non-liquid funding to fully funded systems. c. The determination of the transfer value is extremely problematic. For example, male life expectancy in Latvia is 68 years, whereas in Spain this is 78 years. The reserves which a Latvian pension fund needs to maintain are considerably 30 supplementary pensions were to be dealt with in the same way as private insurance policies, this would have an enormous impact on solvency requirements for supplementary pensions. This could entail significantly larger buffers for pension funds, leading to far more expensive pension schemes, and would have the perverse effect that countries would further nationalise funded systems. Extensive European regulation would also be needed to protect customers from pension misselling or excessive cost loading. Pension entitlements are an element of the labour agreement, however. Harmonised regulations at European level and European supervision would be hopelessly complicated against the background of 27 completely different national systems. Moreover, such a move would go against the principle of subsidiarity, enshrined in the EU treaty. Pieter Omtzigt Member of Dutch Parliament Dutch Parliament has harboured concerns about the portability of pensions for some time now. Implementation could be exceptionally complicated. Besides, a good tracking service with proper provision of information would be an obvious alternative, as is identified by the European Commission itself. The Netherlands with its pensions register provides an excellent example which can serve as a blueprint for a European solution. If such a register is accompanied by limited threshold periods and by protection of deposit funds, the same objective could be achieved more efficiently. Conclusion The announced proposal relating to the portability of supplementary pensions has raised concerns in Dutch Parliament. The European Commission has previously proposed legislation on this issue, and this has been repeatedly rejected for various technical and financial reasons. To conclude, the proposed review of the IORP-Directive could mean that pension funds will be treated as market participants and not as part of a labour agreement. If Pension Background September 2012 no 1 31 Both the Dutch and British pension sector face changes. While both countries started out with similar systems, they moved in different directions, but are now showing signs of converging. What are the lessons the Dutch can learn from the process that the British pension system went through? Knowing the past helps to understand the future The Dutch and British pension sector Converging towards a steady state? The Dutch and the British pension sector were similar up to the 1980s. After that they began to diverge. It is use ful to consider two important differences between the Netherlands and Britain that impacted the directions that were taken: the legal framework and strength of labour unions. The Netherlands, as most of continental Europe, has a legal system based on the Napoleon code, or civil law. Britain, on the other hand, has adapted the system of common law with a stronger focus on individual contracts. In the Netherlands it is possible to change a system by changing the legal code, whereas in Britain the individual contract is considered to be almost holy. The other difference is that the position of the labour unions is more powerful in the Netherlands than in Britain. It is also worth noting that within Britain there is a significant difference in the quality of pension between the unionised sectors and other sectors1. The modern pension system began to develop after World War II; a public PAYG scheme was introduced to reduce immediate poverty for the elderly, while for younger employees an additional final salary DB scheme was introduced. The main difference between the count ries is that the Dutch system has always had a mix of company pension funds and industry-wide pension funds (the first industry-wide pension fund for the dairy industry was founded in 1917)2, whereas the British designed, demographic and career projections were different from today. As is well-known by now, increased longevity and demographic changes have a strong effect on the sustainability of PAYG and DB schemes. When DB and PAYG systems were designed, people on average lived considerably shorter than they currently do and they were expected to have more children earlier in life. Besides that, it was not unusual in those days to have a single employer during your entire career, as opposed to the frequent job switching that is the norm nowadays3. The DB schemes were attractive to employees, as DB schemes are easy to understand and the employer assumed the open-ended pension risks. This system worked well until a combination of longevity, demographics and adverse market conditions put a strain on the system. These problems came to the fore when new accounting standards made the risk associated with the company pension fund explicit on the company’s balance sheet. The volatility of the pension fund began to interfere with the core business of listed companies. This is where the Dutch and the British pension sector headed into different directions, determined to a significant extent by the unions and the legal framework. system is dominated by company pension funds. During the period in which this pension system was Within the British market, we should distinguish between public sector and private sector schemes. In the British private sector, the CFOs wanted to get the volatility of pension liabilities off the company’s balance sheet, so they closed their DB funds and/or 1 3 2 Centre for Policy Studies (2011), Self-sufficiency is the key: addressing For a thorough explanation, the authors refer to Pensions the public sector pensions challenge. Commissions (2004), Pensions: Challenges and Choices, the first SER (2012), In heel Europe moet de arbeidsparticipatie omhoog. report of the Pensions Commission. Pension Background September 2012 no 1 33 went for a buy-out of the pension liabilities4. In their place, individual DC schemes were offered to new employees. By offering these DC solutions, the problem for the employer was solved, as the risk is completely transferred to the employees. The chosen solution is in line with the concept of fairness based on common law: the old contracts are kept intact and new employees get another, much weaker contract. On the other hand, in the British public sector, DB schemes were maintained, and a discussion about the sustainability of the system has only just begun. For most civil servants a DB scheme is offered on the basis of the PAYG principles, while local government employees save for their pension in a funded DB scheme. Since the DB schemes in the public sector are paid out of the government budget, the costs same types of scheme are in place. However, it should be noted that the risk that employers bear is limited. The contributions into the pension scheme can vary, but they are “capped”. This is not a hard cap, but since increasing contributions only has a marginal effect on the financial position of most funds, the current contribution rates may be considered as capped. The different path taken by the Netherlands can be explained by the Dutch concept of fairness based on the civil law code, in combination with strong unions. In the Dutch pension debate, employers and unions were able to renegotiate the pension deal (i.e. change the code) with support from the government. That meant that both old and new employees got the same deal, which prevented a full move towards individual DC schemes for new employees. ‘The pension market lacks the kind of competition on price and quality that we see in normal consumer product markets.’ were not as explicit as in the private sector, which is why it took so long before the change debate started. The difference between the public and the private sector can be explained by the role of the unions. The unions in the public sector are stronger and better in protecting their members, making it harder for the employer to shift all the pension risk to the employee. The Netherlands took a different approach. Instead of replacing the entire DB deal, the risks were partially shifted towards the employee. A move from final salary to average wage was a significant step in making the DB schemes more sustainable. Furthermore, compensation of inflation was made dependent on the financial health of the fund. This system is usually called conditional indexation. For both the public and the private sector, the 4 IPE (2009), 90% of UK DB Schemes now closed. 34 Recent developments While DC is favourable for employers, who can shift risk entirely to the employee, for British employees the actual individual DC experience was disappointing. Participation is as low as 50% in the private sector5, contributions are low and costs are high. This combination has severe implications for the pension outcome. To counter some of the shortcomings of the individual DC schemes offered, particularly the low participation rate, the British government introduced auto-enrolment. Auto-enrolment means that every employee with insufficient pension accumulation automatically participates in the pension scheme of their employer. The employee can opt out if desired. The employer is obliged to offer a pension scheme. This 5 Office for National Statistics (2011), Pension Trends, Chapter 7: Pension Scheme Membership. can either be the pension scheme of a provider, or the National Employment Savings Trust (NEST), which was initiated by the government. NEST is a straightforward DC scheme that operates at arm’s length from the government. Figure 1 Employer liability Traditional DB Conditional indexation Besides these changes, another important trend in Britain is the proposed introduction of Defined Ambition. Steve Webb, the minister of State for Pensions, and his Department of Work and Pensions (DWP) are contemplating whether a type of pension scheme that is in between a traditional DB and individual DC should be possible6. Such a scheme can probably offer a better pension outcome for participants while it might not burden the employer more than the current DC schemes do. Introducing these Defined Ambition schemes is likely to require legislative changes. After the IT bubble, the Netherlands made the move from final wage to average wage pension calculation. The DB contract could be maintained by shifting some of the risk to the participants. However, the interest rate sensitivity of the liabilities, demographic changes and rising longevity expectations have caused concerns on how sustainable the system is in the long run. A renegotiation of the pension deal between employers, employees and the government was initiated, which looked into options like increasing the retirement age and making the retirement age and benefits more dependent on longevity. While the exact outcome of the new Pension Deal is still unclear at the moment of writing this paper, it is expected to look more and more like a collective DC scheme. Learning from past experiences What is interesting to see is that the Dutch and British pension systems, coming from very different ends of the spectrum, now seem to be converging towards something in the middle. Figure 1 illustrates the changes to the pension system in both countries. While both started at traditional DB, the Dutch model, as explained above, moved towards the model of conditional indexation. The British private sector shifted into the 6 Steve Webb (2011), A new future for workplace pensions?, Collective Defined Ambition / The new pension deal? Individual Individual DC No employer liability Individual DC market, while the British public sector still has with the traditional DB model. Both countries however are now searching for a new steady state, as the chosen models have proved to be unsustainable. So what can a steady state look like? Or more importantly: what are the lessons learned from the paths that the two countries took? We will draw some conclusions that are relevant for designing new pension contracts and products. 1. Absence of “The invisible hand” In a traditional market, a buyer and a seller have symmetric information. Services and goods change hands after price negotiations. This process is repeated many times in the marketplace and after a while a market price is formed. Unfortunately the pension market does not work that way. In reality, pension products are sold and not bought. There is a significant information asymmetry between the service provider and the consumer. Financial illiteracy is widespread and people are irrational when it comes to making decisions regarding their pension. Pension, after all, is a low-interest product and requires the ability to think on a horizon of multiple decades. But we only get one chance to get it right; once we are retired it is too late to change our mind. It is well known from academic literature that we as individuals have several behavioural biases that commercial service providers skilfully take advantage of. As a consequence, the pension market lacks the kind of competition on price and quality that we see in normal consumer product markets. In Britain, the market solution experiment resulted in The Telegraph (8 April 2011). Pension Background September 2012 no 1 35 ‘Changes are not implemented overnight and the political decision-making process in both countries only allows for change one step at a time.’ individual pension products with high fees, low participation and low contributions. For the Dutch debate, an important lesson is that someone needs to defend the interests of the individual, and therefore a strong involvement of the social partner is crucial when moving towards Collective DC. 2. Fee level One euro paid in fees is one euro less invested in pension. It may sound trivial, but a lower annual fee is the single most important step towards a good pension in Britain. The compounding effect of costs in pension provision (primarily asset management) is difficult to understand for most individuals. A difference between costs of 0.5% and 1.5% in annual fees might seem mar ginal but the effect over 40 years of pension savings can easily amount to a gain in pension income of over 28%. It is important that the cost of pension is kept to a minimum. Mandatory participation in pension solutions is a great cost saver since it completely eliminates marketing costs. A nonprofit pension fund eliminates the need to pay dividends to a shareholder. 3. Participation ratio The Dutch system and British system differ most significantly in the area of participation. Over 90% of Dutch employees save for their pension, as a result of which old-age poverty in the Netherlands is among the lowest in the world. The British sector, on the other hand, had no strong participation incentives in place, and participation among private sector workers in the employers’ pension schemes has hovered around 50%. Again, mandatory participation can explain this large 36 difference. The British government recently introduced auto-enrolment. While the actual result of this policy change needs to be seen, it is a good step in the direction of increasing participation, especially among low-income earners. In the Dutch context it would be a great improvement if specific groups that are currently outside the Dutch pension fund system, such as the self-employed, could be covered by a collective DC solution. That said, since the British and Dutch pension sectors are moving towards a similar system, both countries should pay close attention to the transition on either side of the North Sea. It is our hope that the outcome of the pension deal discussion in the Netherlands preserves the strengths mentioned earlier, and that the people of the Netherlands will continue to have access to an integrated pension solution in which both the build-up phase and the payout phase proceed in a cost-efficient way. Our predecessors did a great job designing the original DB pension deal given the times they were in. We could ask ourselves what they would have done if they were living today and facing the current challenges. What solution do you think they would have opted for? Ruben Laros Innovation Centre APG 4. Contribution level While the contributions into DB schemes are comparable between the two countries at a level around 20%, the shift towards individual DC in Britain was accompanied by much lower contribution rates. The legislation on auto-enrolment and NEST implies that the contribution will in future be at least 8%. In the past, the British premiums into individual DC schemes were set based on very optimistic return assumptions, leading to low contribution rates. As history has shown, these assumptions have not materialised, leaving many people with inadequate savings for their retirement. In the Dutch pension deal discussion, it is clear that the contribution level should be kept at current levels if/when moving towards a more explicit Collective DC solution. Stefan Lundbergh Innovation Centre APG Towards a new steady state The discussion on what the new steady state in both countries should be ongoing and will remain so for many years to come. Changes are not implemented overnight and the political decision-making process in both countries only allows for change one step at a time. Pension Background September 2012 no 1 37 Colophon Pension Background is an APG publication. Editorial Corporate Communication & Branding Corporate Strategy & Policy [email protected] Photography ANP Photo, Hollandse Hoogte, Masterfile, iStockphoto Subscription Pension Background is a free publication of APG. For registrations, cancellations, or changes of address, please contact: [email protected] or call +31 (20) 604 91 61. For a digital version of Pension Background, see www.apg.nl 38 40.0500.12 APG Gustav Mahlerplein 3 1082 MS Amsterdam www.apg.nl