"Evaluating the Impact of Risk Based Funding Requirements on Pension Funds" evaluates the quantitative funding requirements that would be applied to DB schemes if Solvency II is adopted in its current form. The research was carried out by AllianzGI and risklab germany GmbH, a subsidiary of AllianzGI, together with the Institute of Finance and Actuarial Sciences and is part of a joint research project with the OECD on risk-based regulations. The results of the study are reflected in an OECD policy report on "Funding Regulations and Risk Sharing" which is also being released today. The research explains why Solvency II, if applied in its current guise to DB schemes, could force sponsors to increase funding, change asset allocations and move to a risk-sharing structure.

- There is an ongoing discussion in Europe over the application of Solvency II style rules for pension schemes. The AllianzGI report aims to illustrate how and why DB schemes require a different approach from that applied to insurance companies. Without major amendments, the current Solvency II rules as drafted for insurance companies, if applied to pension funds, could force sponsors to reconsider their commitment to DB schemes.

- DB pension scheme liabilities appear much larger under Solvency II than under the current IAS 19 regulations, the international pensions accounting standard. For a traditional final salary DB scheme, a scheme that is deemed to be fully funded (100 percent) under IAS 19 would only be 64 percent funded under Solvency II.

- Measures that could reduce the resulting underfunding gap under Solvency II for traditional schemes include a change in asset allocation to reduce equities and create a closer match between assets and liabilities.

- An effective measure to counter the impact of Solvency II is a risk-sharing agreement between the sponsor and members. However, some DB schemes with a risk-sharing structure may find only little change in their solvency position, as compared with IAS 19.

- The type of risk-sharing agreement used is very important. While conditional indexation and increased member contributions can help to bridge the gap between the two solvency measures, the most effective risk-sharing mechanism under Solvency II is benefit cuts.

The cost of funding DB schemes is directly linked to the solvency regime, which establishes the level of funding deemed necessary to meet current and projected future liabilities. Any tightening in the solvency rules will have a significant and potentially negative impact on the sponsor’s costs and risks.

A new solvency regime for insurance companies in the EU, known as Solvency II, is being drafted and is expected to come into force at the end of 2009. DB funds currently are excluded from the scope of Solvency II but this year regulators are considering separate rules for pension schemes. If the rules, as currently drafted for insurance companies, are extended to DB funds they could increase sponsor costs significantly. Pension schemes that have a risk-sharing agreement between the sponsor and members are less vulnerable to the risk of underfunding under Solvency II.

Brigitte Miksa, Head of Pensions International, AllianzGI, says, "Solvency II aims to ensure adequate policyholder protection in all EU member states through the requirement for a level of funding that more closely matches the true risks of insurance undertakings. However, DB schemes are quite different from insurance companies and regulators need to reflect these differences in the new rules being drafted this year. Our research shows that to apply Solvency II in its current form could be the final nail in the coffin for DB schemes."

If Solvency II is implemented in its present form the biggest impact will be on traditional DB schemes with no risk-sharing features. A scheme that is 100 percent funded under the accounting rule IAS 19 could be only 64 funded under the new regime.

The analysis was based on the current status of the rules drafted for insurance companies and applied to a range of generic or model pension schemes that are 100 percent funded under IAS 19. The models reflect the characteristics of typical EU schemes in terms of asset allocations and different membership profiles (the proportion of active, deferred and pensioner members, among other categories).

The generic models also reflect different scheme designs, ranging from schemes where 100 percent of the investment and longevity risk is borne by the sponsor to those where risk-sharing agreements share part of these risks with members. Examples of risk-sharing arrangements include the conditional indexation of benefits, the requirement for increased member contributions, and the scheme’s ability to cut benefits. Such features may be triggered automatically for example when funding levels drop to a specific level.

The study shows how schemes could reduce the underfunding that might arise under Solvency II. Gerhard Scheuenstuhl, Managing Director of risklab germany GmbH, explains, "The main drivers of the Solvency Capital Requirement for a typical pension portfolio are interest, equity and longevity risk. To reduce the potential underfunding, schemes would need to make significant changes in asset allocation to reduce their equity and alternatives exposures and also to create a better match between assets and liabilities."

The study found that risk-sharing structures can provide an effective way to reduce solvency capital requirements. Scheuenstuhl says, "A move from unconditional to conditional indexation results in a lower funding requirement due to lower technical provisions and Solvency Capital Requirements but this step would not completely eliminate the underfunding gap. Further work needs to be done on risk sharing as a flexible instrument to mitigate risk. As an extreme version, the employees' agreement to benefit cuts is the most effective arrangement in terms of Solvency II as it currently stands, but most likely it is not the one favored by employees and pensioners."

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