Earlier this year, the Pensions Regulator published its 2015 annual funding statement. Subsequently, it has published a guide for employers on its funding code and new guidance for trustees on assessing and monitoring the employer covenant. Taken together, these documents give a clearer picture of the action the Regulator expects trustees and employers of defined benefit (DB) pension schemes to take to ensure that their scheme is properly funded. Written to give practical advice, the documents should prove helpful reading for both trustees and employers.
In this article, we summarise the Regulator’s key messages.
The 2015 annual funding statement
The 2015 annual funding statement covers the Regulator’s analysis of current market conditions and their impact on the funding of DB schemes. It provides useful information for trustees and sponsoring employers about the Regulator’s approach to reviewing scheme valuations and recovery plans, and is particularly relevant for DB schemes which are undertaking valuations with effective dates between September 2014 and September 2015 (2015 valuations).
It builds on the principles in the Regulator’s revised Code of practice 3: Scheme funding which was published last year.
Key messages for trustees and employers include:
- An integrated approach to managing risks
- The level of risk taken must be appropriate to the circumstances of each scheme and employer. Trustees should set funding strategies with an appropriate level of risk and should document the reasoning behind their decisions.
- Trustees should work with scheme employers to undertake contingency planning and monitoring to enable prompt action to be taken, where necessary, to ensure that risk levels remain appropriate
- Market conditions and their impact
- The Regulator’s analysis of market conditions suggests that schemes with 2015 valuations will have larger funding deficits as a result of not being fully hedged against the risk of falling interest rates.
- Schemes which are relatively unhedged against interest rates and inflation should be aware of the degree of risk exposure that remains unhedged. Trustees should take into account potential future changes in interest rates and inflation when making decisions about their scheme’s level of hedging.
- Investment returns
- Trustees should consider the potential impact on their scheme of different scenarios for investment returns, and should ensure they are comfortable with the level of risk associated with the expected investment return not being borne out.
- The Regulator expects most schemes to set funding strategies based on lower expected returns than at their last valuation.
- Trustees who, at their last valuation, assumed that gilt yields would rise or would rise sooner, should consider the impact that their assumption not being borne out has had on scheme funding and should implement contingency planning as necessary. This could include seeking additional deficit repair contributions (DRCs) or new contingent security.
- Setting appropriate recovery plans
- Trustees should be comfortable with the overall level of risk within any recovery plan, and the recovery period should be appropriate to the scheme’s circumstances. Key factors to consider in agreeing a recovery plan include the scheme’s liability profile, the extent to which the covenant can support downside scenarios, the existence of any contingent assets and the employer’s affordability.
- Longer recovery plans can result in an increase in scheme risks due to lower certainty about the employer covenant and expected investment returns.
- Managing deficits
- Funding strategies should be scheme-specific, reflecting the circumstances of the scheme and the employer.
- While some schemes will have capacity to take additional risk, for example, because of having taken a more prudent approach previously, others will have more limited options for managing risks.
- Where the employer can afford more contributions without adversely affecting its sustainable growth plans, the Regulator expects trustees to seek higher DRCs to maintain the same recovery plan end date.
- Affordability and sustainable growth
- Where the employer’s affordability is constrained and trustees are faced with lower DRCs than they believe the scheme requires, they should undertake a higher level of due diligence on the employer’s affordability and seek to understand why previous levels of contributions cannot be maintained. They should seek to manage the increased risk to the scheme of having a lower level of DRCs by, for example, securing contributions from alternative sources. A robust monitoring process should be implemented.
- If employers are investing in the sustainable growth of their business at the expense of scheme contributions, trustees should seek to understand how this will benefit the employer’s covenant and when increased contributions to the scheme can be expected.
- The scheme should be treated fairly and other stakeholders of the employer should also support its plans, for example, through dividend blocks or restrictions.
- Recent developments
- The funding position of many schemes with 2014 valuations is likely to be significantly worse now than at the valuation date. When finalising 2014 valuations, trustees should take the recent changes in market conditions into account.
- The recent introduction of greater flexibility of access to defined contribution (DC) savings means that members of DB schemes may choose to transfer their benefits to a DC arrangement. This could have a material effect on the funding level of a DB scheme. Trustees should take appropriate advice on the implications of potential increased transfers out on their scheme’s funding assumptions and long-term membership trends.
The Regulator also published two detailed funding statement analyses – one covering funding outcomes for schemes which carried out valuations with effective dates between September 2012 and September 2013, and the other covering schemes carrying out 2015 valuations. These inform the stance taken by the Regulator in the 2015 funding statement.
Guidance for employers on the DB funding code
In July 2015, the Regulator published a new guide to help employers understand how its DB funding code applies to them.
The guide reinforces some of the key messages in the DB funding code, including:
- Trustees and employers should engage in an open, collaborative and transparent manner. Employers are reminded that they will need to provide trustees and their advisers with the information they need to carry out their duties. Trustees, in turn, should understand the potentially sensitive nature of the information provided and any constraints on disclosure.
- Trustees should assess the ability of the employer to address a range of likely adverse outcomes over an appropriate period and should manage the risks associated with scheme funding, scheme investments and employer covenant in an integrated way. The guide urges employers to discuss their long-term plans for their scheme with the trustees and to decide on their appetite for risk so that the trustees can set investment and funding strategies that reflect the employer’s risk appetite and covenant.
- Trustees and employers should work together to reach an appropriate funding strategy which balances the needs of both parties. Where the employer plans to prioritise investment in its business over funding the pension scheme, the trustees will need to understand the nature of those plans and how they will benefit the employer covenant and help fund future contributions to the scheme. The degree of trustee scrutiny should be proportionate to the level and complexity of risk.
- The guide adds that many schemes with valuations in 2015 are likely to face higher than expected deficits due to challenging market conditions, in particular the significant fall in gilt yields.
Guidance for trustees on assessing and monitoring the employer covenant
On 13 August 2015, the Regulator published its latest funding document, good practice guidance on how to assess and monitor the employer’s covenant. This is intended as a handbook for trustees to guide them step by step through assessing the employer covenant. However, its contents will also be of interest to sponsoring employers.
The Regulator expects trustees to take investment and funding risks based on the ability of the employer to support the scheme. A sound understanding of the covenant, the extent of the employer’s legal obligation and financial ability to support the scheme on an ongoing basis, is therefore an essential part of an integrated approach to risk management. The Regulator requires trustees to clearly document the covenant assessment process and its conclusions.
The guidance states that assessing and monitoring the covenant should be proportionate to the circumstances of the scheme and employer (including the degree of reliance of the scheme on the employer on an ongoing basis and the complexity of the employer’s operations). Trustees and employers should work openly and collaboratively together and trustees should consider obtaining independent advice where they lack the objectivity or expertise required to perform an appropriate assessment.
The Regulator stresses that the covenant assessment should focus on entities with a legal obligation to support the scheme - trustees should be cautious about placing
medium or long-term reliance on the continued support of entities without such an obligation but it may be reasonable to rely on informal support in the short term where this has been given in the past and is proposed to continue.
The covenant assessment should focus on the support available from the employer in the context of the funding needs and investment risk of the scheme. The guidance adds that assessments should also be forward- looking and focus on the ability of the employer to contribute cash to the scheme over an appropriate period to achieve and maintain full funding based on an assessment of the employer’s forecast cash flows and the medium and long-term outlook for the business and the market in which it operates.
The Regulator again states that, if the employer’s plans to invest in sustainable growth restrict the funding available to the scheme, trustees should understand how the scheme will benefit by supporting this investment and whether other stakeholders are contributing appropriately. As the covenant can change quickly, trustees should monitor the covenant regularly between valuations and have well- developed contingency plans so they can take decisive action if, and when, required.
Over the coming months, we expect further guidance from the Regulator to complement its DB funding code, including guides on an integrated approach to managing risk and setting an investment strategy.