The Pensions Regulator has issued its first annual funding statement today.  The statement provides guidance on how schemes should approach the valuation process in the context of the current economic climate.  It is aimed at schemes with valuation dates between September 2011 and September 2012. 

The Regulator says that “trustees and employers that follow the guidance… are more likely to reach funding agreements that the regulator finds acceptable without the need for regulatory involvement”.

What should schemes be doing?

In the Regulator’s view, most schemes and employers should be able to meet their pension promises to members with either no change, or only small changes, to their present recovery plans.  However the statement considers some specific issues which might arise because of the current economic position.

  • The Regulator expects valuations to be completed on time.  Trustees should not select an earlier effective valuation date to make use of better economic circumstances.
  • The Regulator reiterates the requirements for prudence when setting valuation assumptions.  In particular “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” and trustees should be sure that the employer could pay any higher contributions required if actual performance fell short of that assumed.  In general, trustees should undertake “contingency planning” in case practice does not reflect the assumptions used. 
  • The Regulator has received a number of requests to allow schemes to incorporate allowances for anticipated improvements in economic circumstances and gilt yields. However, it says “it would not be prudent to try to second guess market movements by assuming that gilt yields will inevitably improve in the near-term. Such assessments may turn out to be inaccurate and conceal important risks to the scheme’s ability to meet its liabilities. Any strongly held views about future financial market conditions should therefore be accommodated in the recovery plan”.  Where schemes exceptionally choose to rely on anticipated changes, they must have viable contingency plans to address the situation where this is not borne out and such plans should be suitably documented.
  • Where schemes are close to funding targets and trustees and employers consider that there could be surplus funding, the Regulator says that “they may wish to consider mechanisms such as an escrow agreement”.
  • The Regulator expects the current level of deficit repair contributions to be maintained in real terms “unless there is a demonstrable change in the employer’s ability to meet them” and that there “should be documented justification where deficit contributions are reduced”. 
  • Where the employer’s covenant has weakened and it cannot afford either higher contributions or even to continue at existing levels, trustees may need to agree to a longer recovery plan. However, a “material extension to the recovery plan end date will require sound justification”.
  • Schemes should be “equitably treated among the competing demands on an employer”.  Where cash is being used within the business at the expense of pension contributions, it should be used to improve the employer’s covenant.  Where an employer cannot pay dividends without prejudice to the funding of the pension scheme, dividend payments need to be re-assessed in light of the obligations to the pension scheme and other creditors.

What the Regulator intends to do next

The Regulator intends to identify schemes where approaches are not in line with its statement and where its intervention may have the greatest impact. It will consider these schemes in more depth and look at “the extent to which trustees have brought the funding, investment and covenant strands together to produce a complete financial management plan, which includes contingency mechanisms to address risk where appropriate”.  It will also engage further with a “very small minority of schemes” during the valuation process.

Further information

The Regulator’s statement can be found here.