Extending Solvency II to pension schemes could cost UK businesses an extra £600bn, report says

Research carried out by investment bank JP Morgan Asset Management found that extending the requirements of the Solvency II Directive to pension funds would cause many pension providers to struggle to hold the required amount of capital.

The increased requirements would particularly affect defined benefit schemes, which promise a set level of pension once an employee reaches retirement age no matter what happens to the stock market or the value of the pension investment, the report said. Last month, an industry report revealed that nearly one quarter of such schemes are now closed to future contributions as companies struggle to manage rising costs.

The report added that tougher governance and disclosure requirements under the scheme would lead to additional work and expense both for pension schemes themselves and their regulators.

Robin Ellison, a pensions law expert with Pinsent Masons, the law firm behind Out-Law.com, said that if implemented as suggested the regime would create "grotesquely inappropriate" liabilities and costs for pension funds and their sponsors.

"This is because the needs of insurance companies - who are trying to kill off competition from the more efficient company pension scheme system in Europe - are not those of company-sponsored pension plans, which do not need the reserves that insurers do," he said.

Solvency II is a draft EU Directive (155-page / 3.7MB PDF) which sets out stronger risk management requirements for European insurers and dictates how much capital firms must hold in relation to their liabilities. The Directive is expected to be finalised later this year, with implementation being phased in from 2013 to 2014.

A consultation by the European Insurance and Occupational Pensions Authority (EIOPA), which closed this week, proposed adapting the rules for use in assessing the solvency of pension schemes. The changes could be implemented as part of the European Commission's review of the Institutions for Occupations Retirement Provisions Directive.

The UK Government has previously spoken out against the proposed changes. Speaking at a conference in London last month, pensions minister Steve Webb described the introduction of regulation similar to that in Solvency II as a "nightmare scenario" which would inevitably lead to pension scheme closures.

However pensions law expert Robin Ellison said that new regulation in the UK had also been a "major destroyer" of company pension plans.

"The politics are complicated, and there is a good chance that the worst will not happen. But if it does, the sensible solution is for UK pension systems to copy the German book-reserve system, creating company pension plans which are excluded from Solvency II," he said.

The £600bn shortfall between assets and liabilities suggested by the JP Morgan report was calculated using Solvency II 'discount' rates, or risk-free interest rates. UK pension schemes currently calculate their assets using the more generous returns available on AA-rated corporate bonds.

Allowing pension schemes to match the returns they generate from some of the assets they actually hold against liabilities of a similar duration could dramatically reduce the deficit - by as much as £200bn for every percentage point increase in the discount rate - the report said.