Fitch: Solvency II Pensions to Benefit Bonds, Hurt Equities

The application of Solvency II to UK defined benefit pension assets could provide an incentive for schemes to move their equity portfolios of £400bn into fixed income securities, Fitch Ratings says. However, this switch is only likely to benefit sovereign or highly rated, short-term corporate borrowers.

The EU’s draft Institutions for Occupational Retirement Provision (IORP) directive seeks to equalise pension provision by insurance companies and employer pension schemes by requiring the latter to comply with aspects of the Solvency II insurance framework. This is likely to require setting up a capital buffer against asset volatility. Despite pensions’ comparatively small share of total assets in Europe, the impact on their allocation decision could be large given the high weighting of pension assets held in equities.

The very low capital charge for low-risk European Economic Area (EEA) government bonds will bolster demand for this asset class. But pension schemes are also likely to demand higher-yielding assets with an efficient capital charge; highly-rated, short-dated corporate bonds (both financial and non-financial) are an obvious choice. The capital charge for a three-year A rated unsecured bond is 3.3% compared with charges for un-hedged equities of 22%. The advantage of holding short-dated bonds over long-dated bonds may be offset by higher requirements for duration mismatch – but the details of any final deal are a long way off.

This additional demand for bonds is unlikely to be of great benefit to non-financial corporate borrowers. The asset class already has a safe haven status with demand outstripping supply. Nor will it help the speculative-grade parts of the market, which are most in need of funding. Capital charges increase dramatically further down the rating scale.

More capital may be directed at unsecured bank bonds, but the positive effects should not be overstated. If additional demand is for short term paper only it will not satisfy banks’ desire for stable longer term funding. Covered bonds attract some of the lowest capital charges of any asset class, bar government debt, e.g. 1.8% is currently proposed for a three-year AAA. This is in contrast to punitive charges for structured bonds. Currency hedging concerns would likely favour UK covered bonds over overseas entities issuing in Sterling.

The 22% capital charge for equities assumes that pension schemes will benefit from the current proposals to allow lower capital charges for equities held against pension provisions – most equities attract a higher charge of 39%. The charge can be brought down by hedging equity downside risk, but this can be expensive and it is unclear whether pension scheme trustees will have the skills or stomach to engage in complex optional strategies.

Real estate and infrastructure may be attractive, if investments can be structured as loans rather than bonds. Insurers are already moving into these markets.

The largest store of EU defined benefit pension assets outside insurance companies is in the UK, where schemes hold about £1 trillion of assets. This number, based on Pension Protection Fund data, was 41.1% in equities and 40.1% in fixed income securities.


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