Pension experts have identified a number of ways in which UK pension funds can escape the potentially calamitous consequences of the European Union's Solvency II directive applying to pension funds

The ideas include extending the Pension Protection Fund's (PPF) guarantee of pension liabilities and gaining the EU's approval to use that guarantee as an alternative to propping up pension funds with massively expensive deficit reductions and extra capital requirements.

Some of these proposed solutions to the Solvency II threat are outlined in an influential JPMorgan Asset Management report on the directive, which uses data from Pension Funds Online. JPMorgan acted as an advisor to groups in the UK who responded to the European supervisory body EIOPA's second call for advice on the new Institutions for Occupational Retirement Provision (IORP) Directive, which closed on 2 January.

Professor Paul Sweeting, European strategy head of JPMorgan Asset Management, said that the firm questions whether a regulatory framework that is designed for large-scale and active insurers "is appropriate for application to pension schemes". He argues that there are a number of ways in which the adverse effect of the proposals on the schemes can be mitigated.

"For example," he says, "allowing for an illiquidity premium in the valuation of liabilities could significantly reduce the impact of new funding rules. In fact, for every 100 basis points (1%) added to the liability discount rate, the aggregate deficit would fall by around £200 billion."

Using the guarantees of the Pension Protection Fund (PPF) to match additional requirements under the new European pensions directive is something that Pensions Minister Steve Webb has already been lobbying for in Brussels.

And Sweeting told Pension Funds Insider that he is confident that Brussels will give the go ahead to use PPF guarantees. That could spare pension funds the entire Solvency II headache.

Tallying the bill

A number of alarming estimates on the cost of Solvency II to UK pension funds have hit the headlines in recent days.

At the top end of these is the £1 trillion figure that JLT Pension Capital Strategies' managing director Charles Cowling has warned of – which was dutifully outlined in its full 13-digit form by a UK national newspaper on 4th January.

Such a staggering cost would be almost certain to end defined benefit provision in the UK. This cost scenario is labelled "excessive and unlikely" by Sweeting, who explains that it factors in the prospect of a minimum capital buffer, akin to what banks and insurance companies will face in future years applying to pension funds.

Sweeting thinks that buffer, known as a Solvency Capital Requirement in the proposals, is very unlikely to force an injection of cash into pension funds. The final directive would allow funds to cover this instead with existing employer covenants or at least financial contingent assets from the sponsor.

The National Association of Pension Funds(NAPF)wrote in its response to the European consultation that any pensions funds "that have sponsor support should not be subject to the Solvency Capital Requirement".

Avoiding the cash buffer means avoiding the full force of Solvency II.

Nonetheless there is still the fear that the new European directive will force British pension schemes to repair the £600bn hole in their finances. That could happen if the alternative 'holistic balance sheet' approach is adopted by Europe, the details and obligations of which are as yet quite unclear.

That is surely enough to keep finance directors with defined benefit pension schemes awake at night. It shouldn't come to this either, Sweeting reassured Pension Funds Insider.

He says that the headline £600bn figure is "what I imagine you would get if pension funds were completely silent and there weren't any consultation responses and consequentially no difference with how the directive applies to insurance companies and pension funds".

In explaining how using the guarantees of the Pension Protection Fund could reduce the bill to zero, Sweeting said: "The 'holistic balance sheet' approach allows the benefits of the PPF to be included as an asset but it is not clear whether you could count it as an asset that could offset the best estimate liabilities or whether you could only offset the Solvency Capital Requirement."

He added that "the protection of the PPF is pretty certain, more so than many investments will be, so there is good reason to include this to offset the best estimate liabilities. If the EU do that and as a following step the scope of the PPF was increased to cover 100% of benefits, then you might not have to put any additional assets into the plan under Solvency II."

The Pension Protection Fund currently insures 90% of pension fund liabilities in the UK.

A spokesperson for the PPF said that the lifeboat was following both the EIOPA consultation proposals and the wider discussion of whether Solvency II should apply to pension schemes closely but would not comment on any specific proposals made in relation to its status.

The NAPF has gone on record to say that "it would be inappropriate to apply a Solvency II-style regime to pension funds in the UK, where members' benefits are already strongly protected by the employer covenant, by the work of the Pension Regulator and by the Pension Protection Fund."

The NAPF warns of a potential £300bn cost to pension funds if the directive were to be implemented in it current guise.

Making a stand

Stories about the alarming consequences of Solvency II for UK pension funds are making many fear the worst. Sweeting, however, is placing his trust in Brussels and is hoping for the best.

His confidence is based on the scale of opposition to implementing the directive for pensions. In the face of such resistance, he believes it "would be perverse if it was brought in regardless."

Sweeting predicts that decision makers at the European Commission will yield to the concerns of the British pension industry in order to protect the struggling European economy: "The economic damage that it would do to the UK as a very large part of the pan-European economy is not good for Europe".

The NAPF has focused on this economic argument too, warning that an application of Solvency II to pension funds could tip the European economy into a 'contractionary cycle'.

The association's chief executive Joanne Segars said that "during these difficult economic times, Europe should focus on fostering growth and job creation. Solvency II type rules would not only put additional pressure on companies that are struggling for survival, but would also force them to divert money away from investment and new jobs."

The large and publicity-hungry alliance that UK pension funds have formed against a punishing new directive on a national and European level is sure to have a significant impact in forming the final directive.

Whether the continued alarm from the pension industry on its costs is due to confident lobbying or fear of not being heard in Brussels is a question that could prove pivotal.

dbillingham@wilmington.co.uk