The Regulator has today (27 April 2012) published the first of its planned annual statements on defined benefit scheme funding. The statement, which contains no surprises, is aimed at trustees and employers of schemes which have effective valuation dates between September 2011 to September 2012. This speedbrief looks at the Regulator's statement.
The Regulator's approach
The 2012 statement sets out the Regulator's views on acceptable approaches to the valuation process in the current economic climate in order to protect members' benefits without undermining employer viability. The Regulator acknowledges that the comments in the statement do not apply equally to all defined benefit schemes because of the diverse nature of those schemes. However, the statement is consistent with the principles which underpin the funding framework.
The statement: economic conditions
The statement comments that the Regulator recognises that current economic conditions put pressure on scheme funding. However, there is sufficient flexibility in the funding framework to address these pressures and achieve an appropriate and balanced outcome. In particular the statement comments:
- There is volatility in deficits as a result of the effective valuation date.
- Low gilt yields have led to scheme liabilities increasing which often leads to a worsening of scheme funding levels. Funding deficits may remain at levels identified at the last valuation despite significant deficit repair contributions over the last three years.
- A substantial proportion of schemes will find that their risk management, asset allocation and contribution strategies, together with (as relevant) prudent allowance for liability reductions as a result of the CPI change, leave them broadly on track to achieve previously agreed recovery plans.
- The employer's ability to afford deficit recovery contributions will vary widely.
- Planning for an uncertain future is a key part of pension scheme management.
The Regulator concludes that the majority of schemes will be able to manage their deficits within the current recovery plans or, where appropriate, with moderate contribution increases and/or modest extensions to recovery plans. These schemes should not need to rely on increases to gilt yields.
The statement: risk management
The Regulator notes that risk management is key for trustees. In particular:
- Trustees should adopt an integrated approach to funding and complete valuations on time.
- Trustees need to document their funding discussions and be in a position to explain their decisions.
- Trustees should undertake contingency planning in case their funding assumptions are not borne out in practice. The details of contingency plans should be proportionate to the level of risk undertaken.
- Trustees should not use an earlier effective valuation date in order to take advantage of more favourable economic conditions. However, where appropriate, the use of actual post valuation experience is acceptable.
- Where schemes are at, or close to, their funding target and trustees and employers consider that market changes and contributions may lead to a funding surplus, they may wish to consider mechanisms such as an escrow agreement.
The statement: technical provisions
In relation to technical provisions the Regulator comments:
- The trustee duty to set prudent technical assumptions for technical provisions applies irrespective of any funding deficit revealed.
- Investment outperformance should be measured relative to the kind of near-risk free return that would be assumed were the scheme to adopt a substantially hedged investment strategy.
- Smoothing of the discount rate is not consistent with the legislative requirement to value assets on a mark-to-market basis. Asset and liability measures should be consistent.
- Any increase in asset outperformance assumed in the discount rate to reflect perceived market conditions is an increase in the reliance on the employer's covenant. The Regulator expects trustees to have examined the additional risk implications for members and be convinced that the employer could realistically support any higher contributions required if actual investment returns fall short of that assumed.
- It would not be prudent to incorporate an allowance for anticipated improvement in economic conditions by assuming that gilt yields will inevitably improve in the short term. Any strongly held views on future market conditions should be accommodated in the recovery plan where they are more clearly identified and mitigated should the assumption not be borne out in practice.
The statement: recovery plans and employer's ability to pay
The statement makes clear that recovery plans should usually be based on reasonable affordability irrespective of economic conditions without compromising the employer's long term ability to support the scheme. In particular the Regulator comments:
- The starting point should be the maintenance of deficit repair contributions in real terms unless there is a demonstrable change in the employer's ability to meet them. Any reduction to deficit contributions must have documented justification.
- The scheme should be equitably treated among the competing demands on the employer. Where cash is used within the employer's business at the expense of what otherwise would have been affordable pension contributions, it is important that it is being used to improve the employer's covenant.
- Where there is a substantial risk to members' benefits, dividend payments need to be re-assessed in light of the employer's obligations to the scheme and other creditors.
- Where the employer covenant has weakened so it cannot afford scheme contributions or is unable to pay off a larger deficit, the trustees may be able to agree a longer recovery plan provided that can be justified.
- Where, exceptionally, schemes do rely on anticipated changes to economic conditions viable contingency plans must be in place (and documented) should the changes not be borne out in practice.
What trustees and employers can expect from the Regulator
The Regulator considers that the statement will enable trustees and employers to reach funding agreements acceptable to it. The Regulator will seek to identify schemes whose funding agreements are not in line with the statement and where regulatory intervention will have the greatest impact. However, the Regulator will engage with a minority of schemes before the valuation process has been concluded. Trustees of schemes which find themselves subject to Regulator scrutiny will need to demonstrate the appropriateness of their complete financial management of the scheme (including contingency mechanisms to address risk).
As expected the 2012 statement contains no surprises - Regulator's primary functions are to apply a flexible funding regime to protect pensions and the PPF. Indeed the thrust of the 2012 statement is very much in line with the earlier statements in 2008 and 2009.
It will be interesting to see how trustees and employers react to the statement in practice. The Regulator indicates that trustees might allow for changes in gilt yields in recovery plans, provided that they can also show (and document) some contingency planning in the event that current market conditions persist. This may lead to trustees seeking a more dynamic link between contributions and scheme experience and business performance.
At the same time, the Regulator's message on cash from employers is much as usual - trustees should be extracting "what is reasonably affordable without compromising the employer's long term ability to support the scheme". Put another way, maintaining shareholder value is not a priority when the real value of deficit contributions should be maintained and this must adversely impact on inward investment.
We understand that the Regulator will be reviewing the funding code of practice and regulatory guidance later this year. It remains to be seen how much substantive change will be made to those documents in practice