Creative Solutions to Cross-Border Pension Challenges
Governments and regulators around the world are preoccupied with major pension issues—employee participation, security of assets and the adequacy of the savings pool—and are implementing new regulations in an attempt to solve these challenges. In EMEA in particular, corporate sponsors of multinational pensions operate within a complex regulatory and market environment. Pensions have traditionally been governed at a local or country level, which makes each pension system (state, workplace and private) unique in each country. Often, where corporate sponsors look to create efficiencies and achieve value they meet challenges in the form of regulation that may incur costs and local fiduciaries who wish to retain control.
As we examine some key challenges and cross-border pension solutions that European multinational firms face, this feature draws upon insights gained from J.P. Morgan’s multinational pension forums held annually in Paris and New York.
The business case for a cross-border pension plan
Typically, a cross-border pension approach involves increased collective decision-making and oversight by the corporate center along with greater standardization of information from the different jurisdictions in which pension plans are held. By successfully implementing a cross-border pension approach, multinational firms can benefit from increased economies of scale and enhanced decision-making, with the ultimate objective of improved pension provisions for employees. There are numerous drivers to a cross-border approach. These fall broadly into the following financial and operational categories:
“Pension constituents can learn the most from their peers and by sharing best practices.”
- Risk management of the multinational’s balance sheet and income statement
- Cost reductions through economies of scale
- Access to risk-adjusted investment options
- Facilitation of multinational asset and liabilities pooling
- Focused and simplified governance structure and operation
- More efficient use of internal management time
- Consistent internal branding and employee experience
As illustrated in figure 1, cross-border pensions can adopt a variety of forms—from a simple global custodian arrangement in which the pension plan’s assets are custodied via a single provider, to an arrangement in which pension plan assets are notionally amalgamated or even physically pooled.
Figure 1:Asset Consolidation Spectrum
Source: Aon Hewitt
A company may choose to be anywhere on this asset consolidation spectrum depending on their current pension arrangements, objectives, timescales and, importantly, their corporate culture and ability to implement change within the organisation. In general, more complex cross-border pension arrangements can achieve greater efficiencies and economies of scale.
However, these structures may be more difficult to implement. Whichever structure is chosen, implementing a cross-border approach requires conviction and resources as well as operational and behavioural changes within the company.
Buy-in of local fiduciaries to a cross-border solution
The support of all stakeholders is required for cross-border pensions to be successfully implemented. This importance is highlighted by a case study where one multinational’s defined benefit (DB) plans held assets greater than its liabilities in one country, whereas two other of its DB plans remained underfunded in other countries. The corporate sponsor proposed paying a benefits increase to the better-funded plan, if the excess assets could be put to use for the underfunded plans, with ring fencing in place. Effectively, this proposal would have dramatically reduced the corporate center’s cost of funding the two underfunded plans. While national regulators in all three countries agreed to the proposal, the trustees of the overfunded plan did not. This presents an interesting example about sponsor covenant and how the long-term benefit to the corporate sponsor, and arguably the plan members, can be blocked by some trustees.
Regulation impacting pensions—one size does not fit all
There is no shortage of regulation impacting pensions. Europe has new pension initiatives that look at a wide range of issues—from whether pension plans need new measures of assets, liabilities and capital requirements to whether regulations recognize the growing importance of defined contribution (DC) funds. Future regulation is being designed to cover all pension plans, both DB and DC plans, regardless of their size or tradition.
However, one size cannot fit all for a variety of reasons. The European pension landscape is varied and diverse on account of country-level traditions (market and industry differences).
In addition, 94 percent of all pension plans in Europe have fewer than 100 members, whereas 90 percent of pension assets are held by the largest pension plans.1 Increased regulation potentially increases the cost of managing pension plans. For smaller plans, this additional cost may be particularly onerous. Another challenge for policymakers is that 60 percent of Europeans have no funded pension provision at all.
Centralized clearing and collateral
Amongst the forthcoming regulatory changes, any entity that uses over-the-counter (OTC) derivatives must prepare to comply with new regulation on centralized clearing and the concomitant collateral requirements.
This regulation concerns not only OTC derivatives subject to mandatory clearing but, in addition, risk mitigation procedures for non-cleared (bilateral)trades.
Under the Dodd-Frank Act in the U.S., centralized clearing has commenced, in a phased approach according to the type of market participant, and there is no exemption for pensions. In contrast, pension plans in Europe have been granted a temporary exemption for hedging contracts under EMIR.2 This is scheduled to last until August 2015 whilst CCPs find a way to take non-cash collateral as variation margin. For pension plans and their corporate sponsors, there will be clear regional differences in the regulatory regimes and considerable implications for liquidity, execution and collateral management. European plans that choose to opt out of centralized clearing under the exemption could experience higher capital charges associated with their derivatives positions.
With hedging strategies becoming more expensive, it makes sense for the corporate center to consider how they can standardize, centralize or create a best practice policy to most efficiently employ their collateral. Yet it’s unclear which approach the corporate sponsor should take. Even the use of a centralized clearing broker is arguably impractical. In the first instance, local plans will have their own banking relationships which they may wish to continue. Furthermore, few clearing brokers will have strong execution relationships across Europe, which means few will be able to access all of the markets required. And, to diversify counterparty risk, some pension plans may prefer to make use of multiple clearing brokers.
The business case for a cross-border IORP structure
Another important regulation impacting pensions is the new Institutions for Occupational Retirement Provision directive (IORP II). The European Commission is revisiting the first IORP directive (also known as the “pensions directive”), looking at three pillars: funding, governance and communications. Whilst the detail of the directive is yet to be written, it aims to facilitate better cross-border pension provision and strengthen protection for scheme members.
The Commission is also seeking to incorporate some fundamentals of the Solvency II regime for insurers into IORP II. However, the inclusion of language surrounding sources of capital, solvency and regulation that has traditionally been applied to insurance companies is challenging for the pension industry.
Notwithstanding its revision, IORPs has already proved an effective approach to pan-European, cross-border pensions offering significant benefits:
- Funding flexibility—a stabilization fund enables trapped surpluses to be avoided
- Central expertise, products and practices
- Uniform practice and enhanced administration service to members
- DB investment consolidation
- DC investment flexibility, enhanced member choice, significantly reduced and transparent charges
- Economies of scale
As always, the key to successful implementation lies in collaboration. Multinationals are more likely to gain the support of all stakeholders involved if they communicate these benefits effectively. A staged approach to implementing IORPs may also be more successful, commencing with DB plans and culminating with the inclusion of DC plans.
Educating and engaging employees
One aspect of the new IORP II directive aims to produce greater transparency and consistency of disclosure within communications. This is already a requirement for mutual funds in Europe, where UCITS3 are required to produce a pre-contractual Key Investor Information Document (KIID). Whether or not this should be applied to pensions remains under discussion.
This is particularly relevant for DC plans, where employees may have less understanding about how to invest and often find too much choice an obstacle rather than an opportunity. Some also find the topic of pensions overwhelming and therefore ignore or delay decision-making. For these reasons, the most effective communications are simple. Rather than adopting a standardized approach, different communication channels and materials need to be based on local, country-level culture and attitudes to savings.
Managing asset and liability risks for the corporation
In today’s global economy, financial markets continue to be volatile, which means we are likely to experience further market shocks affecting the value of assets of all types of pension plans. Furthermore, the pattern with which interest rates will normalize from their current low levels will have a significant impact on the multinational’s balance sheet. For this reason, we need to consider the fundamental interrelationship between pension plan investments and the corporate sponsor. Given the plan’s financial reliance on the sponsoring company, this can present a significant risk as both the corporate sponsor and pension plan assets are affected by common economic factors.
Whilst global economies are linked, they are not perfectly correlated. Therefore, to some extent, multinationals can benefit from geographic diversification. However, many multinational firms operate in the same global sectors in which the plan’s assets are invested, (e.g., oil, telecommunications, banking and insurance). This means they will be impacted by specific sector risks on a global basis, such as resource-based input costs. The ability of the sponsor to address any additional funding requirement for the plan might then be restricted precisely when the need for such a requirement might be heightened.
To protect against joint and simultaneous plan and sponsor stress, the resilience of pension plan portfolios to extreme adverse moves in an identified key variable can be measured, i.e., the element causing the shortfall in the plan’s assets. Based on this analysis, a revised (tilted) asset allocation framework could be applied to mitigate or reduce the impact of this variable with the aim of improving the performance of the plan’s assets.
New solutions are also emerging that allow the corporate center to quantify the effects of single country decisions on its consolidated balance sheet and income statement. These provide the basis for risk management solutions that not only account for the impact on the corporation but also a level of analysis to understand regulatory implications, thereby allowing for greater transparency and more effective decision-making.
Cross-border and IORP pension approaches are widely perceived to offer clear benefits. However, heightened regulation and fiduciary/local governance make it even more challenging for multinational firms to adopt cross-border solutions tailored to the unique liabilities and profile of their pension plans. Effective implementation requires:
- Increased centralization, standardization and transparency
- Accommodation for regulatory and market changes
- Reconciliation for the interests of different pension constituents
Pension constituents can learn the most from their peers and by sharing best practices. Multinational firms also need an effective voice to be heard by the regulator and fiduciaries. For these reasons, there is a growing consensus that there has never been a more important time for input into the pension political and regulatory debate. Indeed, industry and trade organisations are lobbying to demonstrate how proposed regulation could impact the balance sheet and financial health and resilience of corporate sponsors as well as threatening continuing pension provision.
1 EIOPA, “Survey on the implementation of the small IORPs exemption,” 14 September 2012, https://eiopa.europa.eu.
2 “Regulation (EU) No 648/2012 on OTC Derivatives, CCPs and Trade Repositories (EMIR)” contains the EU requirements in respect to central clearing of standardized OTC derivatives; www.esma.europa.eu.
3 Undertakings for Collective Investments in Transferable Securities