Recent sharp falls in equity markets are reported to have reduced the market value of final salary pension schemes’ assets by at least £50bn. At the same time, worsening economic conditions are likely to reduce the strength of many sponsoring employers’ covenants, which may cause pension scheme trustees to consider taking a more cautious approach to funding and investment risk and therefore to seek to fund scheme deficits over a shorter timescale.

Further, an increase in company insolvencies and restructurings is expected to increase the pressure on the Pension Protection Fund (PPF), the statutory body required to pay compensation to pension scheme members when sponsoring employers are insolvent and schemes are in deficit. This would increase costs for all other schemes in the form of higher PPF levies.

All these factors are likely to increase the financial strain on sponsoring employers at a time when cash is at a premium and the cost of borrowing is on the rise. However, other developments offer some good news for sponsoring employers.

The fall in investment values has been partly offset by a drop in the projected value of pension liabilities. In particular, projected inflation has fallen and, with it, the projected costs of pension schemes, which are required to provide limited price indexation on benefits. In addition, because the FRS 17 and IAS 19 accounting standards assume investments in AA-rated corporate bonds, the increased yields on such bonds have resulted in a higher discount rate for pension liabilities disclosed in corporate accounts. Because of this, many companies will be disclosing a pension surplus on an accounting basis.

Nonetheless, pension scheme trustees must of course base their actions on the actual investment positions of their schemes, rather than the accounting positions – and because many schemes still have large investments in equities, we should expect increasing divergence between the two.

Against such a backdrop, recent comments by the Pensions Regulator are all the more helpful. It appears to be downplaying the effect of investment volatility and promoting a balanced approach to funding deficits, and trustees will no doubt be influenced by it. The Regulator is responsible for regulating pension scheme funding under the Pensions Act 2004. Other than for schemes whose trustees have unilateral control over funding, the Regulator must decide actuarial assumptions and employer contributions if employers and trustees fail to reach agreement on funding.

Comments made by the head of the Regulator’s scheme funding unit, Ian Cordwell, to the UK’s National Association of Pension Funds (NAPF) annual conference in Glasgow on 10 October indicate that the Regulator thinks the strength of the sponsoring employer’s covenant, not volatility in scheme investments, is the key issue. The Regulator appears to be comfortable with trustees taking a long-term view of scheme investments: ‘It is very easy to get hyped up about short-term issues, but we need to keep them in context of liabilities that stretch out 40 years or more.’

By contrast, Cordwell said that trustees should consider responding to a weakening in the covenant as soon as possible and not wait until the next scheme valuation is completed. However, the Regulator is discouraging trustees from making funding demands that are unaffordable or put too much pressure on employers:

‘The scheme will have to move down the pecking order in terms of how much they will be able to get from the employer, but trustees have to make sure that the sponsor continues to act into the future… Don’t take the sponsor out of business in the short term because in the long term that will throw the scheme into the PPF.’

The Regulator is also encouraging employers to use contingent asset arrangements – such as security over assets or cross-guarantees – as incentives for trustees to be more accommodating on scheme investment strategies and deficit funding timetables. Depending on their terms, contingent assets can also be used to reduce the PPF levy. Cordwell said to the NAPF that one in five pension schemes now has some form of contingent asset arrangement with its employer and that he expected to see an increase in their use in the short term: ‘This is an area where schemes can potentially bridge the gap where short-term cash may be hard to come by.’

Finally, there is more good news for employers from the PPF. In its annual levy consultation announcement on 25 September, the PPF proposed limiting the increase in its risk-based levy for 2009-10 to the increase in wages. This adheres to a commitment the PPF made in 2007 to keep the levy stable over the next three years, so long as there is no significant change in risk. The PPF chief executive, Partha Dasgupta, said the PPF believed it had to ‘help reduce the burden on levy payers, particularly during the current economic downturn’.

The 2009-10 levy will be confirmed in November, following the end of the annual consultation process.