EIOPA stress tests
Last week EIOPA published the report with the stress test results for pension funds. Ortec Finance contributed to the numbers of some of the Dutch pension funds that provided input to EIOPA.
The objectives of this test were:
- To assess resilience of IORPs to an adverse market scenario. The adverse scenario triggered by a shock to European Union equity markets combines a drop in risk-free rates with a fall in asset prices “double hit”.
- To assess the potential transfer of shocks from occupational pension funds to the real economy and financial markets.
The stress test covered defined benefit (DB) and hybrid as well as defined contribution (DC) schemes.
The European DB and hybrid occupational pension sector has on average insufficient assets to meet pension liabilities on the national balance sheet. These vulnerabilities are even more pronounced on the common, market-consistent balance sheet. The shortfalls on the common balance sheet would need to be covered by increased sponsor support and/or by benefit reductions. The DC occupational pension sector would experience a drop of 15 % in the market value of investment assets in the adverse scenario, reducing the individual accounts of DC pension scheme members.
National recovery mechanisms do allow sponsor support and benefit reductions to be spread over substantial timeframes. IORPs in financial difficulties are usually subject to long-term recovery plans. Moreover, high discount rates provide an optimistic view of the funding situation of IORPs and act to delay recovery plan measures. Such prudential mechanisms may contribute to mitigating the short-term spill-over effects to the real economy and financial stability. However, in case the necessary adjustments are postponed too far, restoring the sustainability of IORPs can only be achieved by putting a disproportionate burden on the younger generations.
Common balance sheet approach
EIOPA’s test was mostly based on the common balance sheet approach. With this, pension funds are asked to value all options like sponsor support, conditional benefits and benefit cuts on their balance sheet. This framework allows EIOPA to compare all countries in a consistent way. However, like the previous stress test two years earlier, this exercise turned out to be rather complicated. The valuation is based on a risk neutral calculation, which heavily depends on the underlying interest rate and does not allow for multiple risk neutral interest rates. The introduction of two different UFR-curves, one introduced by EIOPA which is the basis for the valuation and one published by DNB which determines the actual expectation for the different policy options, made all calculations technically difficult. Furthermore, the test was fully based on a double hit scenario on European markets. The underlying shocks for other countries were significantly lower, which results in very negative results for all pension funds who are heavily invested in de euro region, compared to pension funds which invested more in US and emerging markets. Since in this round this is the only stress test performed, one could question whether a higher risk shown by a pension fund really reflects a higher total risk, when more economic stress scenarios are taken into account.
Results of The Netherlands versus other European countries
The heterogeneity in discount rate conventions results in substantial differences in discount rates between and sometimes within countries. The report shows the lowest weighted average discount rate for The Netherlands compared to the other fifteen DB countries, with a rate only 1.2%. The average national discount rate for all IORPs amounts to 2.1%.
Figure 1: national discount rate in baseline scenario by country, liability weighted average, %
In many countries, the (maximum) length of recovery periods is specified in national regulation. Typical recovery periods vary considerably between countries, ranging from relatively short (< 1 year), medium (3-5 years) and relatively long (up to 10 years). The Netherlands belongs to the latter. Expected return included in recovery plans exceeds the national discount rate 3% in The Netherlands. Other countries which use a recovery plan, the expected return exceeds the national discount rate at most 1%.
All in all, we use a long recovery period and a big difference between the expected return in recovery plans and the discount rate for liabilities.
Figure 2: average expected return on assets if included in recovery plans in baseline scenario and additional recovery plans following adverse market scenario, %
Benefit reductions versus sponsor support
Dutch pension funds are exceptional because of the use of benefit cuts by recovery of the stress scenario. This prevents extra burdens for the younger generations. Within the setup of the common balance sheet, this option to cut benefits results is seen as the balancing item, such that there can never be a negative balance. The stress scenario simply results in lower value of the conditional indexation option and a higher (negative) value of the option to cut benefits. Within this framework, this option is the perfect instrument to prevent shortfalls. Sponsor support is internationally more common, EIOPA however doubts this approach. A lot of funds have a sponsor which is probably not strong enough.
Figure 3: value of benefit reductions in baseline and adverse market scenario, % liabilities excl. benefit reductions