On 5 March 2019 the Pensions Regulator (Regulator) published its annual defined benefit (DB) pension scheme funding statement. The statement trails the Regulator’s approach to scheme funding which is expected to be set out in the new draft funding code due in 2019. This Insight looks at the Regulator’s 2019 statement and its implications.
To which schemes does the 2019 statement apply?
The Regulator is clear that the 2019 statement is particularly relevant for DB schemes with valuation dates between 22 September 2018 and 21 September 2019. It is also relevant for schemes undergoing significant changes which require a review of their funding and risk strategies.
What is different about the 2019 statement?
The annual funding statement was originally issued to comment on economic conditions and their implications for the funding of DB schemes. In its 2019 statement the Regulator sets out the approach it expects trustees and employers to take in relation to DB scheme funding. In particular the Regulator expects trustees and employers to agree a long-term funding target (LTFT). This LTFT looks beyond the scheme’s scheme funding target. The Regulator considers that this LTFT reflects the Government’s intention (as set out in the March 2018 White Paper) that scheme’s should have a long-term funding strategy.
What is the LTFT?
The LTFT is the DB scheme’s long-term financial destination which is in excess of fully funded on the technical provisions basis. This may be, for example, buy-out, self-sufficiency or transfer to a DB consolidator. It is likely that the LTFT will form part of the Regulator’s new approach to scheme funding which will be set out in the new code of practice. Once the trustees and the employer have set the LTFT they must be prepared to evidence that their shorter-term investment and funding strategies are aligned to the LTFT.
How are trustees and employers to manage risks?
In addition to the integrated management of the employer covenant, investment and funding risks, the Regulator expects trustees to take into account the risks arising from the scheme’s maturity. The 2019 statement lists the factors which the Regulator will take into account when it assesses the overall risk profile for each scheme. These factors include:
- the level of cash contributions paid to the scheme
- the additional deficit that could arise from the investment strategy in the future, and whether the covenant could support it
- the strength of the scheme’s technical provisions relative to a prudent valuation, the employer’s strength and the scheme’s maturity
- the length of the recovery plan relative to the level of the deficit, strength of employer covenant and scheme maturity
- the steps taken by trustees to challenge covenant leakage and secure a fair deal for the scheme
- the quality of any agreed contingency plans
- any risks to members which do not appear to be supported by the employer covenant
- the evidence presented regarding the analyses carried out and the scheme’s understanding of the risks.
The 2019 statement sets out tables which contain the key risks the Regulator expects trustees to focus on and the actions they are expected to take for ten different categories of scheme based on covenant strength, funding position and maturity.
How should trustees and employers achieve equitable treatment for DB schemes?
The 2019 statement is clear that the DB scheme is a key financial stakeholder which should be treated equitably with other stakeholders. The Regulator remains concerned about the disparity between dividend growth and stable deficit reduction contributions (DRCs) as well as other forms of covenant leakage which may be occurring at the cost of higher DRCs and shorter recovery plans. The Regulator expects that:
- where shareholder dividends exceed DRCs there should be a strong funding target and a relatively short recovery plan
- if the employer is tending to weak or weak, DRCs should be larger than shareholder distributions unless the recovery plan is short and the funding target is strong
- if the employer is weak and unable to support the scheme, payment of shareholder distributions should have ceased.
How will the Regulator approach long recovery plans and other interventions?
The Regulator intends to intervene in a greater number of cases. These include where there is a significantly long recovery plan. Schemes selected for this intervention will cover the whole covenant spectrum.
The statement notes that the median recovery plan length is seven years. However, for schemes with strong covenants the recovery plan should be significantly shorter than this.
The Regulator plans to engage where it has other concerns about the scheme’s funding and investment plans. Trustees and employers must be able to justify the approach that they have taken with evidence of robust negotiations having taken place.
In its 2019 statement the Regulator is continuing to set out how its tougher approach to DB scheme regulation will work. In addition, the 2019 statement is a clear indication as to what the draft code of practice on scheme funding is likely to contain. In short employers will be under a lot of pressure to pay higher contributions into their DB schemes. This may cause some difficulty for employers in the event of tough trading conditions and the ongoing Brexit uncertainties. It will be interesting to see how this new approach of the Regulator plays out: it definitely highlights the (possibly) irreconcilable tension with the Regulator’s statutory objectives to support employers’ sustainable growth as well as to protect against claims on the Pension Protection Fund.