The unknown corporate liability
Extended version of article published in "Finansavisen" September 26th 2018
From January 1st 2019, Norwegian pension funds will meet greatly increased capital requirements, similar to the Solvency II rules. Enterprises with pension funds may end up with a considerable debt not currently shown in the accounts, and which presumably are unknown to most investors. There has been an extensive debate regarding the new capital requirements, not least in the pages of the Finansavisen. A number of parties have warned strongly against the introduction of Solvency II requirements for pension funds. A main argument is that Solvency II is unsuitable for long term pensions savings, and may reduce pension benefits. Le mieux est l’ennemi du bien, to quote Voltaire.
We will not restart that discussion here. However, we will point at what was the main reason why the rest of Europe said no thanks to Solvency II for pension funds. and warned Norway against introducing such rules – the fact that the new requirements may place extreme and totally unreasonable burdens on sponsors of pension funds. In fact, considerable new liabilities may surface, liabilities currently not shown in sponsors’ accounts under Norwegian generally accepted accounting principles. History is full of examples of pension liabilities suddenly appearing from nowhere and bringing down companies. We’re all well served by that not being repeated.
The Solvency II requirements, developed for the insurance industry, has a very different impact upon pension funds than upon widely diversified insurance companies. Insurance groups may in total get reduced capital requirements under Solvency II logics, based on the premise that if one part of the business develops poorly, another may do well. The pensions funds, however, have only one line of business, and their capital requirements are based on the premise that absolutely everything may go wrong at the same time. Twice in a row.
The Ministry of Finance has assured Parliament that the new requirements will not send pension funds into a crisis. According to the Ministry, all Norwegian pension funds are «well in line» to meeting the requirements as from January 1st 2019. That is correct, as far as it goes, However, two essential points are missing from the description.
First of all, that calculation is based on the use of transition rules, which entail that only a little less than 20% of the increased requirements will have to be met on January 1st 2019. The Financial Supervisory Authority of Norway has previously calculated that at the start, using the transition rules, pension funds will on average have a 160% coverage of the capital requirements. That is a lot less comforting when more than 80% of the new requirements are not taken into the ratio. And the obvious problem with transition rules is that they are transitory. Without transition rules, the situation is very different. According to the FSAN own calculations from 2016, transition rules will the first year ensure that 22,8 BNOK of the underlying and long term capital requirement becomes invisible.
Secondly, this description fails to mention that the new capital requirements will also be highly volatile, and that the pension funds thus will need considerable buffers over and beyond the minimum requirement. At the time the life insurance company Silver was taken under public administration, the company had a mix of liabilities quite similar to a pension fund. Silver was subject to Solvency II, without transition rules. The public administrator assumed that a reasonable buffer would be 50% more than the minimum capital requirement. A full Solvency II calculation then concluded that Silver had a capital shortage of almost 3 BNOK (or approx 30% of pension liabilities). If we add a similar buffer requirement to pension fund shortages, the long term need for new capital of a number of pension funds may be in the hundreds of millions or or even billions of NOK.
The long term challenge of the pension fund becomes the immediate problem for the sponsor / employer. When a pension fund needs additional capital, there is in practice no other source than the sponsor. That sponsor liability is under current accounting practice normally not shown in sponsor accounts. That liability may also be unknown to investors or creditors, with all that entails.
An example may illustrate: Two employers have exactly the same pension liabilities. Company A has secured their pension promises through a group policy with an insurance company, company B has established their own pension funds. In the event that the insurer carrying the pension scheme of company A faces capital shortages, that would be a problem for the owners of the insurance company – not for company A or the owners of company A. However, if the pension fund of company B faces capital shortages, that is an obvious liability for company B and their owners. Under current Norwegian accounting practice, both companies - everything else being equal- would show identical liabilities. Company B however may have a substantial additional liability, which is not accounted for nor reported.
International accounting standards does not provide any good answers to this problem, quite simply because this is a particularly Norwegian challenge. The rest of Europe does not apply Solvency II to pension funds. Accounting for pension liabilities is not a big issue as long as the pension fund and the sponsor perform approximately the same calculation, or where the sponsor may even account for a higher liability than the pension fund.
There is clearly a need for sponsors of pension funds to think through accounting for and reporting of pension liabilities again. The auditors obviously need to engage with the situation. There is probably also a need to revisit accepted accounting standards for pension fund sponsors.
Reporting is one side to the issue, but the actual financial consequences is another. The bill may become large, and volatile on a 24/7 basis. In order to make use of transition rules, there must be a plan for how the transition to fully capitalized status will take place. A practical consequence of applying transitions rules is that the sponsor has taken on the responsibility of providing an unknown amount of capital, as and when required. One possibility is to capitalize the pension fund to the rafters immediately, but that capital then becomes lost or dead from the point of view of the sponsor. The sponsor may alternatively offer a formal guarantee for against future liabilities, but under the proposed detailed regulations that will have to include an even greater amount, in order to secure against counter party risk for the pension fund. Changing the pension scheme is an option, assuming that has not already been done, but that is unlikely to reduce current pension liabilities.
Alternatively, the employer may consider using the rights given under terms of the EEA agreement and the EU Internal Market. Freedom of services principles apply just as much to pension funds and pension schemes as to banking and insurance. There are opportunities for having pension funds under more suitable regulation in other EU / EEA countries. And after all, when Nordea moved HQ from Sweden to Finland to avoid what was in relative terms minor issues compared to what the pension funds face, it may be high time to evaluate a transfer for the pension fund as well?