EU's IORP Directive to be implemented within two years

The Directive on the activities and supervision of institutions for occupational retirement provision (IORP) is not uniquely concerned with cross-border provision - it also affects occupational pension schemes with members in just one member state. Nevertheless, providing the member states can also align their taxation policies, the Directive may succeed in making pan-European pension provision a reality.


Summary of key points

  • A new EU Directive concerning institutions for occupational retirement provision (IORPs) has been published. Member states have two years in which to incorporate its provisions into domestic legislation.

  • IORPs are regulated by the competent authorities in their home member state.

  • An assessment of the liabilities assumed by an IORP must be undertaken by an actuary or similar specialist every three years, with certification or reports in the intervening years.

  • Funds should normally be fully funded to cover the liabilities, but IORPs operating in a single member state can temporarily drop below this level. This is not permitted, however, for IORPs with cross-border membership.

  • The Directive defines the "prudent person" principle in relation to choosing investments.

  • In general, member states must not prevent an IORP from investing up to 70% of its assets in equities — in cross-border IORPs, this can be limited to equities traded on regulated markets.

  • Member states must allow employers located within their territory to sponsor IORPs authorised in other member states; and allow IORPs authorised in their territory to accept sponsorship by employers located within the territories of other member states.

  • Member states cannot restrict IORPs from appointing investment managers and custodians established in another member state.

    The Directive on the activities and supervision of institutions for occupational retirement provision is not uniquely concerned with cross-border provision - it also affects occupational pension schemes with members in just one member state. Nevertheless, providing the member states can also align their taxation policies, the Directive may succeed in making pan-European pension provision a reality.

    The definitive textof a new European Union (EU) Directive1 concerning the activities and supervision of institutions for occupational retirement provision (IORPs) has now been published in the EU's Official Journal. Directive 2003/41/EC, the so-called IORP Directive, should enable pension funds for the first time to take full advantage of the internal market and, in most of the member states, the euro. It puts a framework in place which ought to allow pension institutions to operate more efficiently, while ensuring some common standards of protection for members and pensioners. Member states are required to have transposed its terms into domestic legislation by 23 September 2005.

    Scope of the Directive

    The Directive will apply in general to IORPs, as defined in box 1. From a UK perspective, this definition clearly covers any funded occupational pension scheme, which would include a funded, but not an unfunded, unapproved retirement benefit scheme. It could possibly also cover a group personal pension arrangement or a designated stakeholder pension scheme.

    Member states have the opportunity to modify the scope of the Directive in three areas. First, they can opt to include within its scope the "occupational retirement provision business" of insurance companies, provided this is ring-fenced and managed separately from other insurance business. Second, they can opt not to apply the Directive in whole or in part to any IORP in their territory that has less than 100 members in total ("members" here includes pensioners and deferred pensioners). Third, they can exempt public service schemes from many of the key provisions except those relating to the investment rules.

    Regulation by "home" member states

    The Directive stipulates that each member state must register every IORP located in its territory and, through its appointed regulator, ensure that they are run effectively. It also sets out detailed provisions relating to the information to be provided by these IORPs to their national regulator and lists the powers of intervention and duties of these regulators. From a UK perspective, the current conversion of the Occupational Pensions Regulatory Authority into a "New Kind of Regulator" will need to take these requirements into account.

    The Directive lists various disclosure of information requirements (see box 2) that IORPs must make to their members and beneficiaries. These provisions will mostly be familiar to UK pension administrators. The provision likely to be problematic is the requirement that members should receive details each year of the "current level of financing of their accrued entitlements". The recent Green Paper on pensions published at the end of last year flags up that this requirement is likely to be interpreted in the UK on the basis of the value of the member's accrued benefits available if the scheme were to be wound up.

    "Technical provisions"

    Under article 15, a "home" member state must ensure that IORPs establish at all times for their pension schemes "an adequate amount of liabilities corresponding to the financial commitments which arise out of their portfolios of existing pension contracts". (The home member state is the member state in which the institution has its registered office and its main administration.)

    In particular where IORPs operating occupational pension schemes:

  • provide cover against risks linked to death, disability and longevity (known as "biometric risks" in the Directive), or

  • guarantee a given level of benefits or stated level of investment performance,

    the home member state must ensure that such IORPs establish sufficient "technical provisions" in respect of the total range of these schemes.

    "Technical provisions" is a curious term but refers to what would normally be described as "liabilities". The Directive allows the calculation of these technical provisions to be carried out once every three years rather than annually, but only if the IORP provides certification or a report on adjustments for the intervening years. This would have to cover the "adjusted development" of the technical provisions and the changes in the risks covered.

    The calculation must be carried out by an actuary or "by another specialist in this field, including an auditor", according to the home member state's domestic legislation, but on the basis of actuarial methods recognised by the home state's regulator. The rest of article 15 deals with the principles governing the calculation of the technical provisions.

    Mark Dowsey of Watson Wyatt comments that article 15 appears to support a move to a more scheme-specific funding basis than the UK's current minimum funding requirement (MFR). For example, he points out that it requires that any tables relating to biometric risks should be based on "prudent principles" having regard to the particular characteristics of the scheme, provided that the methodology adopted remains generally constant from one year to the next. "There appears to be a risk, however, that the requirements of the Directive run contrary to developing practice in the UK", says Dowsey. He adds: "The trend is to use a best estimate of most assumptions with margins for prudence explicit in, for example, the investment assumption. The Directive seems to require margins in most, if not all, assumptions."

    Funding technical provisions

    Article 16(1) of the Directive stipulates that each member state must require that all IORPs established in its territory have "at all times sufficient and appropriate assets to cover the technical provisions in respect of the total range of pension schemes operated". Solicitors Freshfields Bruckhaus Deringer comments that this requirement is very similar to the UK's current MFR, and presumably any long-term, scheme-specific, funding standard that emerges as a successor to the MFR will also be designed to comply with article 16(1).

    Nevertheless, despite the categorical nature of this provision, article 16(2) makes provision for home member states to allow an IORP, for a limited period of time, to have insufficient assets to cover its technical provisions. If so, the home regulator must require the IORP to adopt a concrete and realisable recovery plan, whereby all the technical provisions are once again fully covered, and article 16(2) sets out several detailed requirements that any such recovery plan must meet.

    Whenever an IORP is involved in cross-border activities (ie the IORP has accepted sponsorship from an employer operating in a member state other than the one in which it is itself located), article 16(3) requires the home member state to ensure that the technical provisions must at all times be fully funded in respect of the total range of pension schemes operated. If this condition is not met, the regulator in the home member state must intervene as set out above. Actuaries Lane Clark & Peacock wonders if requiring an IORP always to be fully funded where it has a sponsoring employer located in another member state could in practice act to undermine cross-border membership.

    Investment rules

    At the time the European Commission was seeking consensus among the member states for this Directive, the world's equity markets were booming. Those states in which pension funds were free to hold unlimited investments in equities could claim to have regulations preferable to those that applied rigid quantitative limits on the kinds of investments a pension fund could hold. It is ironic, therefore, that the success of the Commission in liberalising the pension fund rules come at a time when equity values have plummeted and funds with a lower proportion of their investments in shares have benefited.

    The Directive requires any IORP operating in the member state in which it was established to invest in accordance with the "prudent person" rule - a concept familiar to those knowledgeable about UK trust law, but one that has had to be defined if it is to become workable on the European mainland. The Directive sets out six rules (see box 3) with which all IORPs must comply.

    Freshfields Bruckhaus Deringer points out that this is the first time that legislation has tried to spell out the nature and extent of what in the UK are the fiduciary duties owed by pension fund trustees and which have been developed by the courts over the years. It comments: "Inevitably there are points of detail that are different." The law firm points out that the Directive as referring to the "best interests of members and beneficiaries" and that no mention is made to this being the "best financial interests" as the phrase was circumscribed in the Cowan v Scargill case ([1984] IRLR 260). Also, it has been argued in the UK that trustees should consider the interests of employers in the light of their sometimes being "beneficiaries" of the trust. In contrast, article 6 sets out various definitions for the purposes of this Directive and "beneficiary" is limited to "persons receiving retirement benefits".

    In addition to the six prudent person rules, the Directive requires member states to prohibit IORPs from borrowing or acting as a guarantor on behalf of a third party (eg a sponsoring employer), although member states may authorise IORPs themselves to borrow but only for liquidity purposes and on a temporary basis.

    Liberalising measures

    The main liberalising measures laid down by the Directive are as follows. A member state:

  • must not require IORPs located in their territory to invest in particular categories of assets;

  • must not subject the investment decisions of an IORP located in their territory, or its investment managers, to any kind of prior approval or systematic notification requirements (but this is without prejudice to the separate requirement that every IORP must prepare, and review at least every three years, its own written statement of investment policy principles);

  • may, for IORPs located in their territories, lay down detailed rules, including quantitative rules, provided they are prudentially justified, to reflect the total range of pension schemes operated by these IORPs, but these rules must not prevent IORPs from investing up to 70% of the assets covering the technical provisions (or the whole portfolio for schemes in which the members bear the investment risk) in shares, negotiable securities treated as shares, and corporate bonds that are traded on regulated markets (note that, providing it is prudentially justified, a limit lower than 70% can be imposed on those IORPs that provide retirement products subject to a long-term interest rate guarantee, bear the investment risk and themselves provide the guarantee);

  • must not prevent IORPs located in their territories from deciding the relative weight of securities in their investment portfolios;

  • must not prevent IORPs located in their territory from investing up to 30% of the assets covering technical provisions in assets denominated in currencies other than those in which the liabilities are expressed; and

  • must not prevent IORPs from investing in risk capital markets.

    Weasel words?

    These liberalising measures are introduced by article 18(5) of the Directive. However, article 18(6) gives a great deal of latitude over their application.

    Article 18(6) deals solely with the liberalising measures forbidding (i) in general, a limit lower than 70% of the assets that can be held in shares, (ii) a limit lower than 30% of the assets that can be denominated in other currencies from those in which the liabilities are expressed, and (iii) any ban on investing in risk capital markets. In relation just to these three measures, article 18(6) states that member states are not precluded from applying to IORPs located in their territories more stringent investment rules on an individual basis provided they are prudentially justified, in particular in the light of the liabilities entered into by the institution. As Mark Dowsey of Watson Wyatt comments: "This might appear to undermine these controls on investment restrictions."

    Restrictions on cross-border IORPs

    In cases where an IORP has accepted sponsorship from an employer operating in a member state other than the one in which it is itself located, ie the IORP is involved in cross-border activities (see below), the regulatory authorities can impose certain additional investment rules set out in article 18(7) of the Directive. If these are applied, they will only apply to the part of the IORP's assets corresponding to the activities carried out in that particular host member state. Furthermore, such rules can only be applied if the same or stricter rules also apply to IORPs located in the host member state.

    These potential article 18(7) restrictions are that:

  • the IORP must not invest more than 30% of the relevant assets in shares, other securities treated as shares and debt securities which are not admitted to trading on a regulated market; or the IORP must invest at least 70% of the relevant assets in shares, other securities treated as shares, and debt securities which are admitted to trading on a regulated market; and

  • the IORP must not invest more than 5% of the relevant assets in shares and other securities treated as shares, bonds, debt securities and other money and capita-market instruments issued by the employer and no more than 10% of the relevant assets in the same kinds of investment issued by employers belonging to a single group.

    Cross-border activities

    The Directive makes a two-pronged provision that should allow a multinational employer to operate a single pension fund established in one member state but which can cover all its employees wherever located within the EU.

    Article 20 stipulates that any member state must:

  • allow employers located within its territory to sponsor IORPs authorised in other member states; and

  • allow IORPs authorised in its territory to accept sponsorship by employers located within the territories of other member states.

    Any IORP wishing to accept sponsorship by an employer located in another member state must be authorised by the regulator in its home state. It must inform that authority of the names of the sponsoring employers in each of the other member states in which it will be operating, and the main characteristics of the pension schemes to be operated for those employers. Providing the regulator has no problem with how the IORP is run, it should transmit the relevant information to the regulator in the other member state or states within three months of the original application by the IORP.

    The regulator in the host member state then has two months to inform the regulator in the home state of any requirements of social security or employment legislation that will apply to the IORP's operation in the host member state, and of any article 18(7) restrictions that will apply (see above). The home regulator must then pass this information on to the IORP. This channel remains open so that, if there are any subsequent significant changes in the host member state's requirements that will affect the IORP's operation in that member state, this will be communicated by the host regulatory authority to the home regulatory authority, which in turn informs the IORP itself.

    The IORP will be subject to the ongoing supervision by the regulator in the host member state. If any irregularities are brought to light, the same communication channel will operate, with the host state regulator informing the IORP's home state regulator so that the home state regulator, in coordination with the host state regulator, can take the necessary measures to ensure that the IORP puts a stop to the detected breach. As a long stop, the host state regulator can prevent that IORP from operating for that employer in its territory.

    Management and custody

    The Directive provides that the principle of freedom to provide services throughout the EU applies to investment management and custody operations. Member states cannot restrict IORPs from appointing investment managers and custodians established in another member state.

    Member states are not prevented from making the appointment of a custodian by an IORP compulsory.

    Next steps

    The domestic legislation does not need to be in place until 23 September 2005 (two years after official publication of the Directive), although the UK government may want to complete the process during the parliament ending in autumn 2004.

    For the UK, much of the importance of the Directive is said to lie in its cross-border provisions, but real advances in this area will also depend on the outcome of the European Commission's current legal action against six member states in the European Court of Justice (OP, March 2003). These states do not allow tax deduction of pension contributions to funds located in other member states, while allowing such deductions in the case of contributions paid to funds in the home state. This action comes in the wake of the recent cases of Danner (OP, November 2002) and Skandia (OP, August 2003).


    Box 1: Definition of an IORP

    "Institution for occupational retirement provision" (IORP) means an "institution, irrespective of its legal form, operating on a funded basis, established separately from any sponsoring undertaking or trade for the purpose of providing retirement benefits in the context of an occupational activity on the basis of an agreement or a contract agreed:

    - individually or collectively between the employer(s) and the employee(s) or their respective representatives, or

    - with self-employed persons, in compliance with the legislation of the home and host member states,

    and which carries out activities directly arising therefrom" (article 6).

    Each member state is required by the Directive, in relation to all IORPs located within its territory:

    - to limit their activities to "retirement-benefit related operations and activities arising therefrom" (article 7); and

    - to ensure there is a legal separation between an IORP and the sponsoring employers in order that its assets are safeguarded in the event of the bankruptcy of the sponsoring employer (article 8).

    Source: IORP Directive, articles 6, 7 and 8.


    Box 2: Information for members and beneficiaries

    "1.Depending on the nature of the pension scheme established, each member state shall ensure that every institution located in its territory provides at least the information set out in this article.

    2.Members and beneficiaries and/or, where applicable, their representatives shall receive:

    (a)on request, the annual accounts and the annual reports referred to in article 10, and, where an institution is responsible for more than one scheme, those relating to their particular pension scheme;

    (b)within a reasonable time, any relevant information regarding changes to the pension-scheme rules.

    3.The statement of investment policy principles, referred to in article 12, shall be made available to members and beneficiaries and/or, where applicable, to their representatives on request.

    4.Each member shall also receive, on request, detailed and substantial information on:

    (a)the target level of the retirement benefits, if applicable;

    (b)the level of benefits in case of cessation of employment;

    (c)where the member bears the investment risk, the range of investment options, if applicable, and the actual investment portfolio as well as information on risk exposure and costs related to the investments;

    (d)the arrangements relating to the transfer of pension rights to another institution for occupational retirement provision in the event of termination of the employment relationship. Members shall receive every year brief particulars of the situation of the institution as well as the current level of financing of their accrued individual entitlements.

    5.Each beneficiary shall receive, on retirement or when other benefits become due, the appropriate information on the benefits which are due and the corresponding payment options."

    Source: IORP Directive, article 11.


    Box 3: The prudent person rules

    "(a)The assets shall be invested in the best interests of members and beneficiaries. In the case of a potential conflict of interest, the institution, or the entity which manages its portfolio, shall ensure that the investment is made in the sole interest of members and beneficiaries;

    (b)the assets shall be invested in such a manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole.

    Assets held to cover the technical provisions shall also be invested in a manner appropriate to the nature and duration of the expected future retirement benefits;

    (c)the assets shall be predominantly invested on regulated markets. Investment in assets which are not admitted to trading on a regulated financial market must in any event be kept to prudent levels;

    (d)investment in derivative instruments shall be possible insofar as they contribute to a reduction of investment risks or facilitate efficient portfolio management. They must be valued on a prudent basis, taking into account the underlying asset, and included in the valuation of the institution's assets. The institution shall also avoid excessive risk exposure to a single counterparty and to other derivative operations;

    (e)the assets shall be properly diversified in such a way as to avoid excessive reliance on any particular asset, issuer or group of undertakings and accumulations of risk in the portfolio as a whole.

    Investments in assets issued by the same issuer or by issuers belonging to the same group shall not expose the institution to excessive risk concentration;

    (f)investment in the sponsoring undertaking shall be no more than 5% of the portfolio as a whole and, when the sponsoring undertaking belongs to a group, investment in the undertakings belonging to the same group as the sponsoring undertaking shall not be more than 10% of the portfolio.

    When the institution is sponsored by a number of undertakings, investment in these sponsoring undertakings shall be made prudently, taking into account the need for proper diversification.

    Member states may decide not to apply the requirements referred to in points (e) and (f) to investment in government bonds."

    Source: IORP Directive, article 18(1).


    Our research

    Our research has been based primarily on a reading of the Directive itself. We have also drawn on commentaries issued by solicitors Freshfields Bruckhaus Deringer and by actuaries Lane Clark & Peacock, Mercer Human Resource Consulting and Watson Wyatt.

    1The text of the Directive is published in the Official Journal, L235, p.10, 23.9.03, and can be found on the EU website (www.europa.eu.int/index_en.htm ) via "EU Documents", "EUR-LEX" and "Search Engine" under Official Journal, and then entering the publication details.