British workers could see pensions cut up to 20 per cent under European rules that govern insurance company capital requirements.

The pain will be felt by those with defined contribution pension schemes, in which money is used to buy an annuity on retirement, which pays out a fixed income until death.

The proposed EU Solvency II rules, which are poised to be introduced in 2012, oblige insurers to be more aggressive in marking annuity liabilities to market, increasing volatility on balance sheets and forcing them to raise capital levels. Insurers are likely to pass on resulting added costs to pensioners in the form of lower incomes.

Mark Wood, chief executive of Paternoster, a pension buy-out group, said: “If Solvency II comes in its current form, then defined contribution pension pots are going to be worth something like 20 per cent less.”

The industry has been told it needs to mount a campaign to force changes in the rules before European regulators finalise how they should be implemented early next year. Lord Turner, head of the Financial Services Authority, said this month that the UK regulator had little power to act since the high-level laws were passed by the European parliament in April. “We have to be realistic about the extent to which the FSA ... can influence this debate,” he told the Association of British Insurers. “The challenge for the industry is to get involved in the debate.”

Big UK insurers such as Aviva and Legal & General, and smaller specialist pension companies, bankers and analysts, said the impact on the value of UK retirement income would be significant. The issue has added importance for the UK, where companies are increasingly switching from defined benefit pension schemes to defined contribution arrangements.

The Solvency II rules were drafted during a relatively benign period for markets. But the financial crisis and its effects on corporate bonds have exposed a weak spot for UK annuity providers, which typically invest more than half of policyholders’ money in such paper.

“At the widest corporate spread levels during the credit crisis, the impact would have been much more than 20 per cent,” said John Pollock, an executive director at L&G. “Now that markets are somewhat better it has come down, but would still be between 10 and 20 per cent.”

Teddy Nyahasha, solvency director at Aviva, would not put a figure on the impact but said: “In terms of ... Solvency II as it is, we are talking about significant multiples of what we deem reasonable to hold against long-term annuity business. These costs would ultimately be passed on to customers.”

Though many believe that the issue will primarily hit the UK because it has the highest proportion of private annuities in Europe, others argue it has a wider impact. David Rogers, chief accounting officer at Aviva, said: “The challenge is to show regulators in other countries that this is a problem that is heading in their direction, especially in those countries with mature demographics.”

In the long-term, some believe insurers will eschew higher capital levels in favour of investing all their annuity funds in much safer assets and paying pensioners’ incomes based on rates that are lower than government bonds.

Ian Gladman, joint head of financial institutions at UBS, said: “This will mean lower income.”

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