EU Pensions Regulation: Liberalisation of Pension Investment

EU Pensions Regulation:
Liberalisation of Pension Investment
2002 Dr Jean-Philippe Chetcuti. All Rights Reserved.

1. Introduction

Whilst the Community has already equipped itself with a comprehensive set of prudential rules for banks, insurance companies, investment firms and investment funds, supplementary pension funds remained the only major financial institutions to be exclusively regulated at national level.

2. Investment Regulation

The investment controls currently in force in some MSs impose restrictions on the manner in which pension funds can be invested.  Some MSs have in place a variety of rigid quantitative thresholds regulating pension investment.  These take the following forms:

  • rules imposing a minimum holding of government bonds or government capital projects, e.g. housing, e.g. until recently, France required a minimum holding of half of the pension fund assets in government bonds;
  • rules limiting holdings of assets with relatively volatile returns: equities, real estate, foreign assets, emerging economies, e.g. Germany limits investments in shares in companies located in the EC to 30%;
  • rules limiting self-investment.

Reasons for regulation of pension portfolio distributions

The paramount justification claimed by MSs imposing such restrictions is that they protect pension fund beneficiaries.  More realistically, some rules actually assume a marked role in ensuring a reliable source public finance through government bonds.  For instance, French caisses de retraite must invest at least 50% of their assets in government bonds.  More implicitly, some other states close off all alternative investment routes, such as international diversification, and leave fund managers no choice but to invest in government bonds.

Other rules seek to reduce to a negligible minimum the extent of risk that pension funds are exposed to in the event of sponsor insolvency.  In the wake of the Enron collapse, the possibility of beneficiaries-employees losing not only their job but also their pension is now more tangible than ever.

The Case for the removal of national investment restrictions

There is dissatisfaction with the current state of the investment framework in place in some MSs at the national level for the following reasons:

No real contribution to security or to capital markets

To start with, the degree to which quantitative investment regulation actually contributes to benefit security is doubtful.  Pension funds, unlike insurance companies, face the risk of increasing liabilities and the risk of holding assets, and hence the need to trade volatility with return.  They need to link pension promises to the long term growth of the real economy.  Moreover, appropriate diversification of assets can eliminate any particular risk from holding an individual security, thus minimising the increase in risk, and international investment will actually reduce otherwise undiversifiable risk.

Furthermore, portfolio regulation restricts the benefits to the capital markets from the development of pensions funds. Thus, where pension funds are compulsorily funnelled into government bonds, which must themselves be repaid from taxation, there may be no benefit to capital formation and the funded schemes may at a macroeconomic level be equivalent to PAYG.  General restrictions also complicate and obstruct the functioning of an efficient capital market and increases the cost of raising capital for companies and the public sector.

Inefficiency, higher costs

The Commission found that investment rules that are over-restrictive and incompatible with EMU and with modern portfolio management techniques tend to unnecessarily limit fund performance.  Back in 2000, Internal Market Commissioner Frits Bolkestein noted that in countries where fund managers were free to decide on asset allocation, pension funds performed twice as well as those with restrictive rules, without undermining security: Between 1984 and 1998, Irish pension funds had on average a real return of 12.5%. Danish pension funds, with notably stricter limits on equities, reached only 6.15%.  The reason is that quantitative restrictions are inflexible and so that investment decisions cannot respond rapidly to changing economic circumstances and movements in the securities, currency, and real estate markets.  Moreover, these restrictions encourage fund managers conformist with the legal restrictions rather than strive for optimal performance.

As a result, employers and beneficiaries in excessively regulated countries receive much lower rates of return than those accruing to their counterparts in MSs with more liberal approaches to pension investment.  Typically, these restrictions result in increased pension contributions and indirect labour costs or in decreasing pension benefits, and can have a detrimental effect on the attractiveness of funding pensions to employer-companies and on the generosity of provision.  Inadequate investment diversification can also increase risks unnecessarily.

Frustration of the goals of EU capital market integration

The benefits which EU capital market integration seeks to achieve can be translated into growth, job creation and competitiveness.  Heterogeneity and restrictiveness of investment rules tend to obstruct such goals and frustrate the goals of an EU-wide capital market.

Inefficient allocation of capital

Quantitative investment restrictions encourage the inefficient allocation of capital, thereby preventing levels of economic growth and increases in employment attainable without such restrictions.

Labour immobility, increased cost of labour

Under their present state, domestic pension systems present insurmountable difficulties for cross-border pension scheme transfers.  The difficulties of joining a supplementary pension scheme established in another MS hinder labour mobility.  Moreover, companies operating in several MSs are forced to establish a pension fund in each MS and are deprived of the economies of scale they could enjoy by using a single fund.  There again, the impact on labour costs is highly negative.  Restrictions also increase the contributions that are to be paid by employers to ensure that employees receive a satisfactory retirement income. This pushes up labour costs and hinder job creation in the Community.

General v. Individual level restrictions

Quantitative investment restrictions and currency matching requirements cannot and should not be retained generally.  However, in a system where the Board of Directors is responsible and accountable and when the asset allocation is fund-specific, self-imposed rules on an individual basis can be useful.

Thus, whilst there should be no general currency matching requirements in the EU, these could be justified on an individual fund basis at the discretion of the Board. For investment outside the EU, convertible currencies should be distinguished from non-convertible currencies. The former, such as the US dollar and yen, should be allowed in all circumstances while, for nonconvertible currencies carrying a specific quality and liquidity risk, a prudent Board should decide whether or not they can invest moderately in such currencies.

The case for the prudent man standard

As noted by Commissioner Bolkestein, small changes in returns can make a huge difference a 0.5% increase in administrative costs or reduction in return on assets means a 20% reduction in final pension.  To avoid unnecessary rules which increase administrative costs of pension funds, the EU should learn from the success story of the prudent person system in a number of countries, as shown in the table below.

Prudent person principle

Substantial quantitative investment


United States

United Kingdom


















Table of annual average of real total return in local currency (1984 1998).

3. The Proposed Directive

History and treaty basis

In the past, the Commission has twice put forward a specific interpretation of the Treaty rules for pension funds.  In 1993, a draft Directive was withdrawn because the amendments proposed by MSs would have legitimised restrictions on pension funds rather than liberalised them.  A 1994 Communication was recently annulled by the ECJ on the basis that the Commission intended to impose new binding obligations on MSs.

The European Council in Lisbon on 23-24 March 2000 addressed the theme of social protection, a fundamental objective of the EU, in terms of Article 2 of the EC Treaty.  The Council mandated a study on the future evolution of social protection from a long term point of view, giving particular attention to the substantiality of pension systems in different time frameworks up to 2020 and beyond.  The Lisbon Council meeting provided impetus for economic reform and set a new strategic goal for the EU, namely to become the most competitive and dynamic knowledge based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion .

The Lisbon Council highlighted the priority of integrating financial services and markets within the Union.  In line with Article 56 of the Treaty, Consensus was reached on five key areas of the Action Plan considered fundamental to the achievement of a genuine single market in financial services by 2005: a single passport for equity issues, enhanced comparability of companies financial statements, eliminating barriers to pension fund investments and undertakings for collective investment in transferable securities (UCITS) and a fundamental review of the Investment Services Directive.

Policy objectives of the proposed Directive

Security: the protection of members and beneficiaries

Attempts, between 1991 and 1994, to pass a Directive on Pension Funds through the Council failed partly because the Commission concentrated exclusively on investment and management rules, leaving prudential issues to MSs.  This time, the Directive tackles investment and prudential rules together. The primary goal of the Commission is to ensure that pensions be secure and that pensioners and future pensioners have a very high degree of protection of their acquired rights.

Removal of unnecessary investment restrictions

However, pension arrangements need also to be efficient and affordable. The standard of prudence in investing is applied to the portfolio as a whole, rather than to individual investments.  The Directive seeks to improve investment performance by limiting regulations to the minimum really necessary to adequately safeguard members and beneficiaries.  The Directive removes any requirements on pension funds to invest or to refrain from investing in particular categories of assets, or to localise their assets in a particular MS, except as justified on prudential grounds. Any restrictions imposed on prudential grounds will have to be proportional to the objectives they may legitimately pursue.


Another aim of the Directive is the diversification of assets, including diversification into assets denominated in currencies other than that in which the liabilities of the institution are established.

Mutual recognition

Rather than adopting a harmonisation stance, the Directive allows for mutual recognition of regulations and supervisory authorities, with the aim of gradual convergence.

A level playing-field between IORPs

Fund managers who are authorised in accordance with the Investment Services Directive, the Second Banking Directive or the Third Life Insurance Directive should be able to offer services all over the EU.  The Directive opens to pension fund managers a wider and more liquid capital market created by the Euro and the single capital market, and which extends globally in total freedom or at least with minimal restrictions.  IORPs which offer products similar to those sold by life insurance companies should be governed by similar rules in certain aspects.

Article 18: The Prudent Person Approach to investments

Freedom of investment and the ability to invest in equities for the longer term are essential to achieving returns that can in turn ensure affordability.  Such freedom should only be restricted by qualitative prudential principles, hence the EUs choice of the prudent man standard.  Thus freedom of investment should entail a high level of responsibility and accountability on the part of the Board of Directors.  This constitutes a major step towards the affordability of funded pension provision.

In the words of the Commissions Recommendations, Efficiency requires this and best practice imposes it. For them to translate into real security, prudential principles should be implemented and supervised at all times and at all levels.

A European Code of Best Practice

Prudence constitutes a fiduciary duty of the Board of Directors towards the plan and its members and beneficiaries, as well as the plan sponsor. The collective duty of prudence of the Board of Directors amounts to the behaviour expected of a prudent person managing his or her own affairs.  At the basis of the European Code of Best Practice inherent in the Directive are the five prudential principles of security, profitability, diversification, quality and liquidity.


The principle par excellence of the prudential duty is security.  This is in line with the primary aim of providing adequate pensions to members and beneficiaries whatever the pension type. The following prudential principles remain subject to the principle of security.

Efficiency and profitability

Inefficiency, whether on the liability or on the asset side, as well as in administration and disclosure, leads to expensive and less affordable plans and therefore optimisation of all aspects of the pension fund is of the utmost importance.  The way assets [should be] invested must be commensurate with the nature and duration of corresponding liabilities.


Prudence of asset allocation requires the reduction of risk by proper diversification in terms of issuers, types of securities, country or geographical zone, currency and industrial sector. Rules requiring diversification as well as rules limiting significant investments in the sponsoring undertaking, should therefore be in place to prevent Enron-type employee misfortunes.


In support of security, this principle refers to the quality of whole process of pension fund management and of the assets themselves.


Being fund-specific, it is up to the Board to ensure liquidity of the fund as a whole.  Thus a young fund can afford more liquidity risk and asset class risk than a mature or a supermature fund.

The list of prudential principles is not exhaustive and countries and individual funds can add other principles such as ethical criteria for investments and equal representation.

The Responsibility of the Board of Directors

As the main decision-making body of a pension fund, the Board of Directors needs to be competent, honourable, responsible and accountable to the members and beneficiaries, as well as to the sponsor(s) and the Supervisory Authority.  The Board needs to apply ongoing due diligence so that its decisions remain appropriate over time.  Members of the Board should be carefully selected and should be well trained. The publication of an annual report ensures full accountability and transparency and annual audited accounts should be presented to the sponsor(s), the members / beneficiaries and the Supervisory Authority.

In the discharge of their fiduciary duties, Board members should be assisted by actuaries, money managers, custodians, auditors and investment consultants. Good pension fund governance is about board members delegating their duties to the best available internal and external specialists.  However, like directors of companies, Board members can never delegate their control function and will always have the final responsibility for the whole process of asset and liability management, for administration and disclosure.

Investment Parameters

Under Article 18, MSs will be able to subject funds to more detailed investment rules as long as they allow pension institutions to invest:

  • up to 70% of technical provisions (in the case of DB pension funds) and up to 70% of the whole portfolio (in the case of DC pension funds) in shares, negotiable securities and corporate bonds;
  • in non-matching currencies for at least 30% of technical provisions;
  • in risk capital consistent with prudent person concept;
  • not more than 5% in the sponsoring undertaking.

Moreover, MSs may not require institutions to invest in particular categories of assets.

Sub-article 7 provides a general escape clause: if prudently justified and exclusively on a case by case basis, MSs may impose more restrictive rules than otherwise allowed by the Directive.

4. Obstacles to the adoption of the Directive

Prudential vs Quantitative tug of war

The Commission, through Pragma Consulting, has based itself on very wide input from the market in order to determine the ideal shape of EU pension fund regulation. Nonetheless, the Commissions point of departure lies in fifteen very different markets, fifteen different types of social arrangements and fifteen different systems of fund supervision.  One tough barrier to break will be that rising between those MSs with a long-established prudent person principle and those which are completely alien to this investment principle.  The commission faces the test of the consensus building process which has to convince the latter group of MSs that the shift from quantitative to qualitative investment regulation is not one which eliminates all rules indiscriminately.  It has to demonstrate the soundness of ensuring that at any point in time, the investment portfolio is secure, profitable, diversified and liquid.  The Commissions proposed approach is a qualitative approach to supervision enabling each fund to reach the most appropriate balance between security and affordability, instead of applying one rigid set of rules to all institutions across the EU.

This is very much in line with UK practice; however, it is foreign to several MSs who believe in more extensive quantitative restrictions on investment policy to protect pensions. The latter group led by France and Germany raise the story of the Maxwell raiding of the Mirrors pension fund ten years ago as a defence of their restrictive approaches.  On the other hand, the UK, Ireland, Sweden and the Netherlands which back the prudent principle proposals argue that returns over the past 15 years were twice as high in the UK and the Netherlands as in MSs subject to quantitative restrictions.

The Spanish delegation has proposed what is being labelled prudent person plus – the basic prudence person principle fortified with some quantitative restrictions the details of which are not available at the time of writing.

Other areas of contention

Key areas of contention which are likely to trouble MSs in the debate on the Directive are limits on pension fund exposure to high-risk investments such as private equity, hedge funds and derivatives. The level of investment in real estate is another issue in dispute. While such restrictions are common in several MSs, their potential introduction has raised alarm in the UK and the Netherlands.

Spain is pushing member states to resolve disputes over such issues before its presidency ends in June. Denmark, which will take over the rotating presidency, is understood to be willing to support the Commission directive, providing it gains some political support.  But the presidency then passes to Greece and Italy, two countries where the commitment to pension reform is uncertain.

Mr Rubenstein says there is a danger that a compromise could emerge where states adopt the prudent person principle while putting restrictions on pension funds operating within their borders. This multi-layered approach may not be too different from the status quo.

5. Conclusion

While the Directives failure to address the differing tax treatment of pensions may prevent any attainment of several benefits of any pension move, it seems that the Commission is quite adamant over its prudential approach, and rightly so. Commissioner Bolkestein has repeatedly said that a more restrictive approach which could imply a setback for countries such as the UK, would not be acceptable for the Commission in which case they would shelve it. It would be unfortunate not get a Directive at the time when the political awareness of the need for pension reform in the first pillar and the need to rebuild and reinforce the second pillar is greater than ever.


Proposal for a Directive of the European Parliament and of the Council on the activities of institutions for occupational retirement provision

Article 18

Investment rules

1. Member States shall require institutions established within their jurisdiction to invest in a prudent manner.

2. Assets held in relation to schemes where the members bear the investment risks shall be invested in accordance with the following rules:

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

(b) the assets shall be properly diversified in such a way as to avoid accumulations of risk in the portfolio as a whole;

(c) investment in the sponsoring undertaking shall be no more than 5% of the portfolio as a whole. When the institution is sponsored by a group of undertakings, investment in these sponsoring undertakings shall be made prudently, taking into account the need for proper diversification.

3. Member States shall require institutions established within their jurisdiction to invest assets held to cover the technical provisions in accordance with the following rules:

(a) the assets shall be invested in a manner appropriate to the nature and duration of the expected future retirement benefits and to ensure the security, quality, liquidity and profitability of the portfolio as a whole;

(b) the assets shall be properly diversified in such a way as to avoid accumulations of risk in the portfolio as a whole;

(c) investment in the sponsoring undertaking shall be no more than 5% of the technical provisions. When the institution is sponsored by a group of undertakings, investment in these sponsoring undertakings shall be made prudently, taking into account the need for proper diversification.

4. Member States shall not require institutions to invest in particular categories of assets.

5. Member States shall not subject the investment decisions of an institution or its investment manager to any kind of prior approval or systematic notification requirements.

6. In accordance with the provisions of paragraphs 1 to 5, Member States may, for the institutions established in their jurisdiction, lay down more detailed rules to reflect the total range of schemes operated by these institutions.

However, these institutions shall be given the possibilities to:

(a) invest up to 70% of the assets covering the technical provisions or of the whole portfolio for schemes in which the members bear the investment risks in shares, negotiable securities treated as shares and corporate bonds and decide on the relative weight of these securities in their investment portfolio;

(b) hold assets denominated in non-matching currencies to cover an amount of at least 30% of their technical provisions;

(c) invest in risk capital markets.

7. The second subparagraph of paragraph 6 does not preclude the right for Member States to require the application of more stringent investment rules on an individual basis provided they are prudentially justified, in particular in light of the liabilities entered into by the institution.


DB Defined benefit
DC  Defined contribution
Directive  Proposal for a Directive on the co-ordination of laws, regulations and administrative provisions relating to institutions for occupational retirement provisions
DMFR  Dynamic minimum funding requirement
ECJ  European Court of Justice
EFRP  European Federation for Retirement Provision
IORP  Institutions for Occupational Retirement Provisions
MS  Member State
OECD  Organisation for Economic Co-operation and Development
PAYG  Pay-as-you-go