Prudential Regulation Authority Rulebook

8.1

This chapter sets the methodology the PRA uses to inform the setting of a firm’s Pillar 2A capital requirement for pension obligation risk.

8.2

Pension obligation risk is the risk:

• to a firm caused by its contractual or other liabilities to, or with respect to, a pension scheme (whether established for its employees or those of a related company or otherwise); and
• that a firm will make payments or other contributions to, or with respect to, a pension scheme because of a moral obligation or because the firm considers that it needs to do so for some other reason.

8.3

Pension obligation risk relates to defined benefit pension schemes and defined contribution schemes offering guaranteed returns that are not fully matched by underlying investments. Hybrid schemes are considered to be defined benefit pension schemes. Pension obligation risk includes the risk arising from overseas pension schemes.

8.4

A sponsoring firm is a firm with contractual or potential commitments to one or several defined benefit pension schemes covering its employees or the employees of another entity within the same group.

8.5

Pension obligation risk manifests itself in different forms. The PRA’s focus is on the impact that changes in value of a pension scheme could have on Common Equity Tier 1 (CET1). Under CRD, the accounting deficit of a firm’s pension scheme is deducted from CET1. Any surpluses are de-recognised. Firms are therefore exposed to pension obligation risk because a material increase in the pension scheme’s deficit under adverse conditions will have a negative impact on their CET1.

8.6

A firm that does not deduct its pension scheme deficit from CET1 (eg because another company within the group recognises the deficit on its balance sheet) may still be exposed to indirect pension obligation risk, where the UK Pensions Regulator (TPR) has the power to require the firm to support the pension scheme, or where the failure of the company that recognises the deficit could destabilise the group, leading to the risk of contagion.

8.7

The PRA does not have a remit to protect members of defined benefit pension fund schemes against the failure of those plans. Nevertheless a firm must at all times comply with the overall financial adequacy rule. Accordingly, the PRA aims to ensure that firms are adequately capitalised against their defined benefit pension obligations.

8.8

The PRA’s framework for Pillar 2A pension obligation risk capital consists of two elements:

• the firm’s own assessment of the appropriate level of Pillar 2A pension obligation risk capital; and
• a set of stresses on the accounting basis which will be used by the PRA in assessing the adequacy of the firm’s own assessment of the level of capital required.

8.9

The firm’s own assessment and the PRA stress tests on the accounting basis can be reduced by offsets and management actions, and any pension scheme deficit deducted from CET1.

8.10

The PRA uses the results of two scenarios it prescribes to assess the adequacy of the firm’s own assessment of the appropriate level of capital and to inform the setting of the Pillar 2A capital requirement for pension obligation risk. The higher of the two stress scenarios will form the starting point of the assessment.

8.11

The two scenarios applicable from 1 January 2016 are set out in Table D.

Table D PRA pension obligation risk stress scenarios (applicable from January 2016)

Per cent

8.12

The PRA recognises that the assumptions underpinning the stress scenarios may not be appropriate for the risk profile of all pension schemes. Where the PRA believes that the risk profile of a firm’s pension scheme deviates significantly from the assumptions underlying the published scenarios, it will use other models to inform the appropriate level of Pillar 2A pension obligation risk capital to compare against the firm’s own assessment.

8.13

For the purposes of the stress scenarios, the PRA expects the valuation measure of liabilities to be the same as that used for IFRS reporting. Firms’ approaches to setting the valuation assumptions should be stable over time and any changes to the approach should be justified in the ICAAP. The PRA will review the robustness of the valuation assumptions and may adjust the surplus or deficit in the capital requirements calculations where the assumptions are found to be out of line with other firms, or where an alternative set of assumptions better satisfies the capital adequacy rules.

8.14

The stress scenarios have been designed to produce an appropriate level of capital for a typical pension scheme. From time to time, it may be necessary to update the scenarios to ensure that they continue to remain appropriate. This may be done, for instance, where significant movements in market conditions mean that the scenarios produce inappropriate levels of capital or where the average risk profile of the pension schemes sponsored by PRA-regulated firms deviates from the risk profile the PRA has assumed when calibrating the stress scenarios.

8.15

The scenarios described in Table D are distinct from the multi-year firm-wide scenarios the PRA expects firms to develop in their ICAAP in accordance with the general stress test and scenario analysis rule in Internal Capital Adequacy Assessment 12.1 in the PRA Rulebook.

8.16

The PRA reviews the scenarios on an annual basis, but only expects to make changes to them every few years. Any changes will be consulted on before being implemented.

8.17

The firm’s own assessment of the appropriate level of capital and the results of the PRA stress scenarios may be reduced by eligible offsets and management actions recognised by the PRA. Offsets are reductions in a firm’s Pillar 2A capital requirement to reflect factors present at the ICAAP effective date which would reduce the impact of a stress on the firm. Management actions are steps the firm could, and would, take when a stress occurs in order to reduce its impact.

8.18

To be accepted by the PRA, offsets and management actions in relation to the PRA stress scenarios should comply with the following eligibility criteria:

• financial performance – the efficacy of offsets and management actions should not depend on assumptions as to the future financial performance of the firm, either before or after a stress;
• independence from the decisions and actions of third parties – the efficacy of offsets and management actions should not depend on assumptions as to the future agreement or behaviour of third parties, either before or after a stress; and
• immediacy – recognised offsets should reflect a risk mitigation benefit that is already effective when the offset is taken. Management actions should be capable of taking effect quickly enough to mitigate the stress to which they are the proposed response.

8.19

The PRA expects firms to explain any offsets or management actions they propose. Where practical, management actions will be formulated after discussion with pension scheme trustees. The PRA will apply the eligibility criteria in a strict manner on a case-by-case basis. Offsets and management actions that do not meet the eligibility criteria will not be accepted.

8.20

The PRA already collects information on defined benefit pension schemes from firms participating in the Stress Testing Data Framework (STDF) programme. All PRA firms with defined benefit pension schemes are required to report the data contained in the pension risk data item in accordance with Reporting Pillar 2, 2.6, unless those data have already been submitted as part of the STDF programme. Firms that are in scope are required to submit the data with their ICAAP submissions.