|
 EU
Pensions Regulation:
Liberalisation
of Pension Investment
©
Dr Jean-Philippe
Chetcuti 2002. All Rights Reserved.
 Describe the attempts made to achieve
liberalisation of pension investment at the EU level and offer some suggestions
as to why attempts to legislate in this field have so far failed.
1.
Introduction
Whilst the Community has already equipped
itself with a comprehensive set of prudential rules for banks, insurance
companies, investment firms and investment funds, supplementary pension funds
remained the only major financial institutions to be exclusively regulated at
national level.
2.
Investment Regulation
The investment controls currently in force
in some MSs impose restrictions on the manner in which pension funds can be
invested. Some MSs have in place a
variety of rigid quantitative thresholds regulating pension investment.
These take the following forms:
-
rules imposing a minimum holding of
government bonds or government capital projects, e.g. housing, e.g. until
recently, France required a minimum holding of half of the pension fund
assets in government bonds;
-
rules limiting holdings of assets with
relatively volatile returns: equities, real estate, foreign assets, emerging
economies, e.g. Germany limits investments in shares in companies located in
the EC to 30%;
-
rules limiting self-investment.
Reasons for
regulation of pension portfolio distributions
The paramount justification claimed by MSs
imposing such restrictions is that they protect pension fund beneficiaries.
More realistically, some rules actually assume a marked role in ensuring
a reliable source public finance through government bonds.
For instance, French caisses de retraite must invest at least 50%
of their assets in government bonds. More
implicitly, some other states close off all alternative investment routes, such
as international diversification, and leave fund managers no choice but to
invest in government bonds.
Other rules seek to reduce to a negligible
minimum the extent of risk that pension funds are exposed to in the event of
sponsor insolvency. In the wake of
the Enron collapse,
the possibility of beneficiaries-employees losing not only their job but also
their pension is now more tangible than ever.
The Case for the
removal of national investment restrictions
There is
dissatisfaction with the current state of the investment framework in place in
some MSs at the national level for the following reasons:
No real
contribution to security or to capital markets
To start with, the degree to which
quantitative investment regulation actually contributes to benefit security is
doubtful. Pension funds, unlike
insurance companies, face the risk of increasing liabilities and the risk of
holding assets, and hence the need to trade volatility with return.
They need to link pension
promises to the long term growth of the real economy.
Moreover, appropriate diversification of assets
can eliminate any particular risk from holding an individual security, thus
minimising the increase in risk, and international investment will actually
reduce otherwise undiversifiable risk.
Furthermore, portfolio regulation restricts
the benefits to the capital markets from the development of pensions funds.
Thus, where pension funds are compulsorily funnelled into government bonds,
which must themselves be repaid from taxation, there may be no benefit to
capital formation and the ‘funded’ schemes may at a macroeconomic level be
equivalent to PAYG.
General restrictions also complicate and obstruct the functioning of an
efficient capital market and increases the cost of raising capital for companies
and the public sector.
Inefficiency,
higher costs
The Commission found that investment rules
that are over-restrictive and incompatible with EMU and with modern portfolio
management techniques tend to unnecessarily limit fund performance.
Back in 2000, Internal Market Commissioner Frits Bolkestein noted that in
countries where fund managers were free to decide on asset allocation, pension
funds performed twice as well as those with restrictive rules, without
undermining security: “Between 1984 and 1998, Irish pension funds had on
average a real return of 12.5%. Danish pension funds, with notably stricter
limits on equities, reached only 6.15%.”
The reason is that quantitative restrictions are inflexible and so that
investment decisions cannot respond rapidly to changing economic circumstances
and movements in the securities, currency, and real estate markets.
Moreover, these restrictions encourage fund managers conformist with the
legal restrictions rather than strive for optimal performance.
As a result, employers and beneficiaries in
excessively regulated countries receive much lower rates of return than those
accruing to their counterparts in MSs with more liberal approaches to pension
investment.
Typically, these restrictions result in increased pension contributions
and indirect labour costs or in decreasing pension benefits, and can have a
detrimental effect on the attractiveness of funding pensions to
employer-companies and on the generosity of provision.
Inadequate investment diversification can also increase risks
unnecessarily.
Frustration of the
goals of EU capital market integration
The benefits which EU capital market
integration seeks to achieve can be translated into growth, job creation and
competitiveness. Heterogeneity and
restrictiveness of investment rules tend to obstruct such goals and frustrate
the goals of an EU-wide capital market.
Inefficient
allocation of capital
Quantitative investment restrictions
encourage the inefficient allocation of capital, thereby preventing levels of
economic growth and increases in employment attainable without such
restrictions.
Labour immobility,
increased cost of labour
Under their present state, domestic pension
systems present insurmountable difficulties for cross-border pension scheme
transfers. The difficulties of
joining a supplementary pension scheme established in another MS hinder labour
mobility. Moreover, companies
operating in several MSs are forced to establish a pension fund in each MS and
are deprived of the economies of scale they could enjoy by using a single fund.
There again, the impact on labour costs is highly negative. Restrictions
also increase the contributions that are to be paid by employers to ensure that
employees receive a satisfactory retirement income. This pushes up labour costs
and hinder job creation in the Community.
General v.
Individual level restrictions
Quantitative investment restrictions and
currency matching requirements cannot and should not be retained generally.
However, in a system where the Board of Directors is responsible and
accountable and when the asset allocation is fund-specific, self-imposed rules
on an individual basis can be useful.
Thus, whilst there should be no general
currency matching requirements in the EU, these could be justified on an
individual fund basis at the discretion of the Board. For investment outside the
EU, convertible currencies should be distinguished from non-convertible
currencies. The former, such as the US dollar and yen, should be allowed in all
circumstances while, for nonconvertible currencies carrying a specific quality
and liquidity risk, a prudent Board should decide whether or not they can invest
moderately in such currencies.
The case for the
‘prudent man standard’
As noted by
Commissioner Bolkestein, “small changes in returns can make a huge
difference… a 0.5% increase in administrative costs or reduction in return on
assets means a 20% reduction in final pension.”
To avoid unnecessary rules which increase administrative costs of pension
funds, the EU should learn from the success story of the prudent person system
in a number of countries, as shown in the table below.
|
Prudent
person principle
|
Substantial
quantitative investment
|
|
Ireland
United
States
United
Kingdom
Belgium
Netherlands
|
13%
11%
10%
10%
10%
|
Germany
Denmark
Switzerland
|
7%
6%
5%
|
|
Average
|
11%
|
Average
|
6%
|
Table of annual
average of real total return in local currency (1984 –1998)
3.
The Proposed Directive
History and treaty
basis
In the past, the Commission has twice put
forward a specific interpretation of the Treaty rules for pension funds.
In 1993, a draft Directive
was withdrawn because the amendments proposed by MSs would have legitimised
restrictions on pension funds rather than liberalised them.
A 1994 Communication
was recently annulled by the ECJ
on the basis that the Commission intended to impose new binding obligations on
MSs.
The European Council in Lisbon on 23-24
March 2000 addressed the theme of social protection, a fundamental objective of
the EU, in terms of Article 2 of the EC Treaty. The Council mandated
“a study on the future evolution of social protection from a long term point
of view, giving particular attention to the substantiality of pension systems in
different time frameworks up to 2020 and beyond”.
The Lisbon Council meeting provided impetus for economic reform and set a
new strategic goal for the EU, namely “to become the most competitive and
dynamic knowledge based economy in the world capable of sustainable economic
growth with more and better jobs and greater social cohesion …”.
The Lisbon Council highlighted the priority
of integrating financial services and markets within the Union. In line
with Article 56 of the Treaty,
Consensus was reached on five key areas of the Action Plan considered
fundamental to the achievement of a genuine single market in financial services
by 2005: a single passport for equity issues, enhanced comparability of
companies’ financial statements, eliminating barriers to pension fund
investments and undertakings for collective investment in transferable
securities (UCITS) and a fundamental review of the Investment Services
Directive.
Policy objectives
of the proposed Directive
Security: the
protection of members and beneficiaries
Attempts, between 1991 and 1994, to pass a
Directive on Pension Funds through the Council failed partly because the
Commission concentrated exclusively on investment and management rules, leaving
prudential issues to MSs. This
time, the Directive tackles investment and prudential rules together. The
primary goal of the Commission is to ensure that pensions be secure and that
pensioners and future pensioners have a very high degree of protection of their
acquired rights.
Removal of
unnecessary investment restrictions
However, pension arrangements need also to
be efficient and affordable. The standard of prudence in investing is applied to
the portfolio as a whole, rather than to individual investments.
The Directive seeks to improve investment performance by limiting
regulations to the minimum really necessary to adequately safeguard members and
beneficiaries. The Directive
removes any requirements on pension funds to invest or to refrain from investing
in particular categories of assets, or to localise their assets in a particular
MS, except as justified on prudential grounds. Any restrictions imposed on
prudential grounds will have to be proportional to the objectives they may
legitimately pursue.
Diversification
Another aim of the Directive is the
diversification of assets, including diversification into assets denominated in
currencies other than that in which the liabilities of the institution are
established.
Mutual recognition
Rather than adopting a harmonisation
stance, the Directive allows for mutual recognition of regulations and
supervisory authorities, with the aim of gradual convergence.
A level
playing-field between IORPs
Fund managers who are authorised in
accordance with the Investment Services Directive, the Second Banking Directive
or the Third Life Insurance Directive
should be able to offer services all over the EU.
The Directive opens to pension fund managers a wider and more liquid
capital market created by the Euro and the single capital market, and which
extends globally in total freedom or at least with minimal restrictions.
IORPs which offer products similar to those sold by life insurance
companies should be governed by similar rules in certain aspects.
Article 18: The
Prudent Person Approach to investments
Freedom of investment and the ability to
invest in equities for the longer term are essential to achieving returns that
can in turn ensure affordability. Such
freedom should only be restricted by qualitative prudential principles, hence
the EU’s choice of the prudent man standard.
Thus freedom of investment should entail a high level of responsibility
and accountability on the part of the Board of Directors.
This constitutes a major step towards the affordability of funded pension
provision.
In the words of the Commission’s
Recommendations, “Efficiency requires this and best practice imposes it.”
For them to translate into real security, prudential principles should be
implemented and supervised at all times and at all levels.
A European Code of
Best Practice
Prudence constitutes a fiduciary duty of
the Board of Directors towards the plan and its members and beneficiaries, as
well as the plan sponsor. The collective duty of prudence of the Board of
Directors amounts to the behaviour expected of a prudent person managing his or
her own affairs. At the basis of
the European Code of Best Practice inherent in the Directive are the five
prudential principles of security, profitability, diversification, quality and
liquidity.
Security
The principle par excellence of the
prudential duty is security. This
is in line with the primary aim of providing adequate pensions to members and
beneficiaries whatever the pension type. The following prudential principles
remain subject to the principle of security.
Efficiency and
profitability
Inefficiency, whether on the liability or
on the asset side, as well as in administration and disclosure, leads to
expensive and less affordable plans and therefore optimisation of all aspects of
the pension fund is of the utmost importance. “The way assets [should be] invested must be commensurate
with the nature and duration of corresponding liabilities.”
Diversification
Prudence of asset allocation requires the
reduction of risk by proper diversification in terms of issuers, types of
securities, country or geographical zone, currency and industrial sector. Rules
requiring diversification as well as rules limiting significant investments in
the sponsoring undertaking, should therefore be in place to prevent Enron-type
employee misfortunes.
Quality
In support of security, this principle
refers to the quality of whole process of pension fund management and of the
assets themselves.
Liquidity
Being fund-specific, it is up to the Board
to ensure liquidity of the fund as a whole.
Thus a young fund can afford more liquidity risk and asset class risk
than a mature or a supermature fund.
The list of prudential principles is not
exhaustive and countries and individual funds can add other principles such as
ethical criteria for investments and equal representation.
The Responsibility
of the Board of Directors
As the main decision-making body of a
pension fund, the Board of Directors needs to be competent, honourable,
responsible and accountable to the members and beneficiaries, as well as to the
sponsor(s) and the Supervisory Authority. The
Board needs to apply ongoing due diligence so that its decisions remain
appropriate over time. Members of
the Board should be carefully selected and should be well trained. The
publication of an annual report ensures full accountability and transparency and
annual audited accounts should be presented to the sponsor(s), the members /
beneficiaries and the Supervisory Authority.
In the discharge of their fiduciary duties,
Board members should be assisted by actuaries, money managers, custodians,
auditors and investment consultants. Good pension fund governance is about board
members delegating their duties to the best available internal and external
specialists. However, like
directors of companies, Board members can never delegate their control function
and will always have the final responsibility for the whole process of asset and
liability management, for administration and disclosure.
Investment
Parameters
Under Article 18, MSs will be able to
subject funds to more detailed investment rules as long as they allow pension
institutions to invest:
-
up to 70% of technical provisions (in
the case of DB pension funds) and up to 70% of the whole portfolio (in the
case of DC pension funds) in shares, negotiable securities and corporate
bonds;
-
in non-matching currencies for at least
30% of technical provisions;
-
in risk capital consistent with prudent
person concept;
-
not more than 5% in the sponsoring
undertaking.
Moreover, MSs may not
require institutions to invest in particular categories of assets.
Sub-article 7 provides a general escape
clause: if prudently justified and exclusively on a case by case basis, MSs may
impose more restrictive rules than otherwise allowed by the Directive.
4.
Obstacles to the adoption of the Directive
Prudential vs
Quantitative tug of war
The Commission, through Pragma Consulting,
has based itself on very wide input from the market in order to determine the
ideal shape of EU pension fund regulation.
Nonetheless, the Commission’s point of departure lies in fifteen very
different markets, fifteen different types of social arrangements and fifteen
different systems of fund supervision. One
tough barrier to break will be that rising between those MSs with a
long-established ‘prudent person’ principle and those which are completely
alien to this investment principle. The
commission faces the test of the consensus building process which has to
convince the latter group of MSs that the shift from quantitative to qualitative
investment regulation is not one which eliminates all rules indiscriminately.
It has to demonstrate the soundness of ensuring that at any point in
time, the investment portfolio is secure, profitable, diversified and liquid.
The Commission’s proposed approach is “a qualitative approach to
supervision enabling each fund to reach the most appropriate balance between
security and affordability, instead of applying one rigid set of rules to all
institutions across the EU.”
This is very much in line with UK practice;
however, it is foreign to several MSs who believe in more extensive quantitative
restrictions on investment policy to protect pensions. The latter group led by
France and Germany raise the story of the Maxwell raiding of the Mirror’s
pension fund ten years ago as a defence of their restrictive approaches.
On the other hand, the UK, Ireland, Sweden and the Netherlands which back
the “prudent principle” proposals argue that returns over the past 15 years
were twice as high in the UK and the Netherlands as in MSs subject to
quantitative restrictions.
The Spanish delegation has proposed what is
being labelled “prudent person plus” - the basic prudence person principle
fortified with some quantitative restrictions – the details of which are not
available at the time of writing.
Other areas of
contention
Key areas of contention which are likely to
trouble MSs in the debate on the Directive are limits on pension fund exposure
to high-risk investments such as private equity, hedge funds and derivatives.
The level of investment in real estate is another issue in dispute. While such
restrictions are common in several MSs, their potential introduction has raised
alarm in the UK and the Netherlands.
Spain is pushing member states to resolve
disputes over such issues before its presidency ends in June. Denmark, which
will take over the rotating presidency, is understood to be willing to support
the Commission directive, providing it gains some political support.
But the presidency then passes to Greece and Italy, two countries where
the commitment to pension reform is uncertain.
Mr Rubenstein says there is a danger that a
compromise could emerge where states adopt the “prudent person” principle
while putting restrictions on pension funds operating within their borders. This
multi-layered approach may not be too different from the status quo.
5.
Conclusion
While the Directive’s failure to address
the differing tax treatment of pensions may prevent any attainment of several
benefits of any pension move, it seems that the Commission is quite adamant over
its prudential approach, and rightly so. Commissioner
Bolkestein has repeatedly said that a more restrictive approach which could
imply a setback for countries such as the UK, would not be acceptable for the
Commission in which case they would shelve it. It would be unfortunate not get a
Directive at the time when the political awareness of the need for pension
reform in the first pillar and the need to rebuild and reinforce the second
pillar is greater than ever.
APPENDIX
1
Proposal for a
Directive of the European Parliament and of the Council on the activities of
institutions for occupational retirement provision
Article 18
Investment
rules
1. Member States shall
require institutions established within their jurisdiction to invest in a
prudent manner.
2. Assets held in
relation to schemes where the members bear the investment risks shall be
invested in accordance with the following rules:
(a) the assets shall be
invested in a manner to ensure the security, quality, liquidity and
profitability of the portfolio as a whole;
(b) the assets shall be
properly diversified in such a way as to avoid accumulations of risk in the
portfolio as a whole;
(c) investment in the
sponsoring undertaking shall be no more than 5% of the portfolio as a whole.
When the institution is sponsored by a group of undertakings, investment in
these sponsoring undertakings shall be made prudently, taking into account the
need for proper diversification.
3. Member States shall
require institutions established within their jurisdiction to invest assets held
to cover the technical provisions in accordance with the following rules:
(a) the assets shall be
invested in a manner appropriate to the nature and duration of the expected
future retirement benefits and to ensure the security, quality, liquidity and
profitability of the portfolio as a whole;
(b) the assets shall be
properly diversified in such a way as to avoid accumulations of risk in the
portfolio as a whole;
(c) investment in the
sponsoring undertaking shall be no more than 5% of the technical provisions.
When the institution is sponsored by a group of undertakings, investment in
these sponsoring undertakings shall be made prudently, taking into account the
need for proper diversification.
4. Member States shall
not require institutions to invest in particular categories of assets.
5. Member States shall
not subject the investment decisions of an institution or its investment manager
to any kind of prior approval or systematic notification requirements.
6. In accordance with
the provisions of paragraphs 1 to 5, Member States may, for the institutions
established in their jurisdiction, lay down more detailed rules to reflect the
total range of schemes operated by these institutions.
However, these institutions shall be given the
possibilities to:
(a) invest up to 70% of
the assets covering the technical provisions or of the whole portfolio for
schemes in which the members bear the investment risks in shares, negotiable
securities treated as shares and corporate bonds and decide on the relative
weight of these securities in their investment portfolio;
(b) hold assets
denominated in non-matching currencies to cover an amount of at least 30% of
their technical provisions;
(c) invest in risk
capital markets.
7.
The second subparagraph of paragraph 6 does not preclude the right for Member
States to require the application of more stringent investment rules on an
individual basis provided they are prudentially justified, in particular in
light of the liabilities entered into by the institution.
| Abbreviations |
|
| DB |
Defined
benefit |
| DC |
Defined
contribution |
| Directive |
Proposal
for a Directive on the co-ordination of laws, regulations and
administrative provisions relating to institutions for occupational
retirement provisions |
| DMFR |
Dynamic
minimum funding requirement |
| ECJ |
European
Court of Justice |
| EFRP |
European
Federation for Retirement Provision |
| IORP |
Institutions
for Occupational Retirement Provisions |
| MS |
Member
State |
| OECD |
Organisation
for Economic Co-operation and Development |
| PAYG |
Pay-as-you-go |
BACK
TO:
 ©
2002
Dr Jean-Philippe
Chetcuti. All Rights Reserved. |
