Pension Plans: a focus on Defined Benefit Pension Schemes

The Pension Act 2004 introduced a set of laws which regulate pension schemes in a manner similar to the Solvency II approach. UK pension regulation, indeed, sets out how a pension scheme should be funded, who manages the supervisory function and how it has to act, how and how many disclosures schemes are required to provide annually to keep the public informed.

However, even if the Pension Act 2004 sets out its provisions similarly to the second and third pillars of Solvency II, there are some important dierences concerning the assets and liabilities of UK pension schemes due to first pillar. UK dened benefit schemes are critically aected by the changes brought about by the new European rules.

A pension scheme is required to have sucient assets to meet its technical provisions. The technical provisions should represent an estimate of the provision needed to meet benefit payments. They take in account the expected investment strategy of the scheme and should include margins for adverse situations that could occur (e.g. An employer appears less able to bear volatility in contributions). If after the scheme's three yearly valuation a shortfall in assets has been revealed, it has to be make up as soon as the employer can afford it. The average recovery period adopted in the UK is c. 6.5 years.

While the bases adopted by schemes can vary considerably, the rate used to discount the projected cash ows is usually derived by reference to either gilt yields or corporate bond yields with an addition to allow for out-performance relative to these from other asset classes held by the scheme.

In contrast, under the first pillar of Solvency II framework, insurance companies must calculate the technical provisions by discounting each future cash ow using an appropriate risk-free rate. If this would happen, and likely it will, pension schemes would be forced to increase their technical provisions.

According to a recent study by Allianz Global Investors (AllianzGI) on Solvency II and its eects on pension schemes, DB pension scheme liabilities appear much larger under Solvency II than under the IAS 19 regulations, the international pensions accounting standard. The research emphasises that, for example, a traditional final salary DB scheme considered to be fully funded under IAS 19 would be 64% funded under Solvency II.

This means that an increase in capital requirements would be needed, which could lead to deep changes in the scheme's asset allocation, encouraging the purchase of risk free assets and the sale of risky assets such as equities and hedge funds. Indeed, the cost of funding DB schemes is directly linked to the solvency regime and any tightening in solvency rules will increase sponsor's costs and risks. Moreover the Solvency II requirements would force insurers to hold enough assets in order to be solvent event in a worst case scenario.