The European Insurance and Occupational Pensions Authority (EIOPA) has launched a consultation on its draft opinion on the supervision of institutions for occupational retirement provisions’ (IORP) exposure to liquidity risks.

Its objective is to enhance convergence in oversight to protect pension fund members and beneficiaries, and to bolster the stability of IORPs and the wider financial system.

The IORP II Directive allows IORPs to invest in derivative instruments to mitigate risks and facilitate efficient portfolio management. Although the use of derivatives for hedging purposes reduces solvency risk in defined benefit (DB) schemes and investment risk for members and beneficiaries in defined contribution (DC) schemes, it also introduces new risks, most notably liquidity risk resulting from the daily exchange of variation margin to cover any market losses on derivatives

In some EU member states, IORPS make considerable use of derivatives. These hedging positions make them vulnerable to rapid changes in interest rates and/or the value of foreign currencies, potentially triggering short-term margin calls that IORPs would need to meet.

The UK gilt crisis in 2022 demonstrated the adverse consequences of inadequate liquidity risk management in relation to derivative positions of pension schemes. UK pension schemes needed to raise cash quickly to meet margin and collateral calls or, in many cases, respond to capital calls from liability driven investment (LDI) funds, as a sharp rise in interest rates resulted in losses on interest rate hedging positions.

“These vulnerabilities underline the need for a thorough assessment of IORPs’ exposure to liquidity risks – including margin and collateral calls, early withdrawals and outgoing transfers – as well as their ability to manage these risks,” EIOPA stated.

EIOPA would prefer a risk-based, forward-looking and proportionate approach and expects supervisors to monitor and assess the liquidity risk exposures of IORPs.

When IORPs are found to have material liquidity risks, supervisors would be expected to assess their ability to manage these risks and to ensure that IORPs exposed to material liquidity risks fulfil some key principles regarding the management of this exposure. This includes stress testing cash flows, drawing up contingency plans and creating a buffer of liquid assets to cover any shortfalls.

EIOPA expects to publish the final opinion in 2025 together with a feedback statement on stakeholders’ responses. All responses will be published on EIOPA’s website unless otherwise requested.

The consultation is open until 20 December 2024 and responses can be submitted via an online survey here.

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