The Pensions Regulator (TPR) has published guidance on how funding valuations should be approached in the current economic climate.
It applies to approximately one-third of the UK’s 6,500 defined benefit (DB) pension schemes, and about 4 million of the 12 million DB memberships.
The guidance is aimed at employers and trustees of DB schemes that are undertaking their scheme valuations with effective dates between September 2011 and September 2012.
The aim of the guidance is to encourage employers and trustees to work with their advisors to begin the process of implementing the approaches to their scheme funding valuations.
The statement provides guidance to trustees and employers as follows:
- There is significant flexibility in the funding framework to enable schemes and employers to meet their long-term liabilities, including, where necessary, filling deficits over longer periods, taking account of improvements to market conditions post-valuation, and the use of contingent security and intra-group guarantees.
- As a starting point, TPR expects that current deficit recovery contributions should be maintained in real terms. It will seek strong justification where a reduction is proposed.
- Capital expenditure, servicing other debts and making dividend payments have an important role to play in encouraging investment in a healthy, sponsoring employer. However, in some cases, dividend payments may need to recognise the shareholders’ subordinate position to the scheme. Where available, cash is used within an organisation that might otherwise have been used to increase contributions it should have the demonstrable effect of strengthening the employer’s ability to support the scheme.
Based on the information TPR holds on schemes, including their previous valuations, it estimates that a significant majority of employers of schemes in deficit will not need to make changes to their existing plans; or will only need to make small increases to their deficit recovery contributions and/or length of recovery plans.
The remainder divide into two groups:
- Employers of significantly underfunded pension schemes for which affordability of contributions is not a major barrier. Employers in this group will need to make larger increases in contributions and/or provide security in the form of contingent assets.
- Employers, with deficits, that are expected to find affordability a challenge. Employers in this group are likely to need to significantly increase their existing deficit recovery plan length and/or make full use of the other flexibilities within the scheme funding framework.
Bill Galvin, chief executive at The Pensions Regulator, said: “The economic climate continues to be challenging, but the majority of schemes and sponsoring employers should be able to meet their promises to members without major adjustments to their current plans. Trustees must produce credible recovery plans in light of all the risks, including employer insolvency.
“Employers that are struggling have greater breathing space to fill deficits over a longer period. However, we will draw a distinction between this group and those cases where schemes are substantially underfunded and employers are able to afford higher contributions. In such cases, we will expect pension trustees to be taking steps to put their scheme on a more stable footing.
“There are a number of economic factors impacting gilt yields, such as quantitative easing (QE) and demands for UK sovereign debt from the international banking sector.
“We have been in a low-interest climate for some time. Yields have fallen further in the last nine months, and it is unclear when and to what extent there will be a market correction. The net effect across DB schemes is not uniform and will vary greatly depending upon the extent to which their risk-management, investment and contribution strategies have insulated them from the effects.”
Stephen Soper, executive director for DB regulation at The Pensions Regulator, added: “We are taking a more segmented approach to regulation and will proactively engage with those schemes where we believe there is greatest risk to member benefits and PPF levy payers, based upon experiences of previous funding cycles.
“Schemes in a stronger position can expect less intervention by us, but we will place more focus on schemes in a weaker position. In those rare situations where the sponsoring employer is so weak that trustees are not able to put together a viable plan, we urge them to contact us as early as possible in the process.”
Joanne Segars, chief executive at the National Association of Pension Funds (NAPF), said: “Tough economic conditions, QE and falling gilt yields have been causing a huge headache for organisations providing DB pensions, many of which have seen their pension deficits go up significantly.
“Pension trustees and those running pension schemes have a difficult job. The Pensions Regulator’s statement will help by giving some much-needed clarity on what they expect from them and the employers who are going through their valuations.
“It is good that TPR will look sympathetically on employers that have experienced significant deficit increases by allowing extensions in recovery periods and, in some cases, allowing recovery plans to take on board any potential improvements in economic conditions.
“However, as the negative growth figures this week have shown, the outlook for the economy remains highly uncertain and there is the possibility that more QE will unfold. While TPR is optimistic that the majority of pension schemes will not need to make significant increases in their contributions, it will need to stand ready to adjust its expectations if the real experience of pension schemes turns out to be far worse.
“While TPR’s statement is helpful, we hope that its dealings with pension funds and their employers are consistent with what it has outlined. Ultimately, the proof of the pudding will be in the eating.”
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Where this statement perhaps goes somewhat further is in stressing the view that any increase in the asset outperformance assumed in the discount rate to reflect perceived market conditions (must be seen) as an increase in the reliance on the employer’s covenant. This may not be a conclusion accepted by all stakeholders and their advisers and this could create some tensions and difficulties.
As a starting point TPR 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”. But the attaching caveat that this “of course assumes that the current contributions were properly set” must, in the ACA’s view, be limited to what we hope are a very small number of unresolved cases. No one expects a re-visiting of previously agreed and accepted recovery plans based on 20/20 hindsight.
The ACA welcomes the confirmations of what the regulated can expect from TPR, although the undertakings stop short of promising consistency of approach or completion of reviews within commercially sensitive timescales.
The flipside of the acknowledgement that the use of cash in a business (including for dividends) might improve the employer’s covenant is surely that an unresolved pension-funding situation might damage the covenant, particularly for high-profile quoted businesses. Reducing, and ideally removing, delay or uncertainty in resolving funding situations is just as important and this is an area TPR needs to address.
The statement implies that TPR might permit the elastic to be stretched a little further than before. On condition that trustees consider what contingency mechanisms they may need to have in place if the elastic snaps. Current market conditions are accepted to be unusual, but may persist for some time yet.
Many tools are available for measuring risk, market impact and covenant strength, but none of these tools is clairvoyant. Although there is regulatory focus on the valuation process, a successful outcome requires judgement and regular monitoring of investment, liability and covenant risk.
Of course, regulators are nervous about pushing boundaries too far. On the other hand, TPR’s press release suggests additional flexibility will not be accepted in all cases, especially where a sponsor can readily meet any deficit, so allowing flexibility will not be an altogether comfortable decision for some trustees.
Trustees need to work with employers to enable outcomes that achieve an appropriate balance of interests between shareholders and scheme members. TPR needs to respect this balance also, in carrying out its role.
You wouldn’t want the captain of your ship to set sail using a navigation system based on last month’s weather conditions. Scheme funding is no different. Trustees and employers should have access to the most up-to-date information so they are better able to navigate their way and are more likely to plot a sensible course to meet their long-term objectives.
We believe this also questions the concept of the traditional triennial valuation. In our opinion, the natural solution is for trustees and employers to monitor actively the financial position of their pension schemes more regularly to ensure they can efficiently navigate through these turbulent economic times and effectively account for any post valuation experience.
Unlike TPR, we think that deficits in this cycle of valuations will be materially higher – after all, liabilities are typically one-third higher than three years ago. Asset values have also increased since March/April 2009.
However, following their 2009 valuations, many schemes’ recovery plans were agreed based on a position after equity markets had recovered in early 2010. Where this is the case, schemes will be looking at deficits, which are far larger than are addressed by their current recovery plans.
In our view, it should be a matter of judgement for individual schemes to decide whether to adjust their technical provisions to reflect current circumstances (including the effects of quantitative easing) and with reference to the strength of their sponsor’s covenant.
For schemes that measure prudence by the percentage chance that they will fail to meet their objective, adjusting the technical provisions calculation basis compared with three years ago may represent a similar degree of prudence in the overall funding.
In some cases, disclosing big deficits could lead to unnecessary concerns and may indirectly damage the employer covenant, which would not be in anyone’s interests.
Short-term adjustments that can be reviewed at the next funding valuation may be just as acceptable as making allowance in a recovery plan for expected changes in financial markets.
As TPR points out, the outcome of a funding discussion may well be the same – driven by what is affordable – but TPR needs to place greater confidence in trustees, sponsors and their professional advisers to determine appropriate solutions.
We also believe that TPR should focus its limited resources on the cases where this confidence is clearly unjustified or where the parties are unable to reach agreement.
TPR was in a very difficult situation. It could hardly permit a wholesale weakening of bases, having spent the last 7 years getting schemes to where they are.
Therefore, tackling this in the recovery plans is entirely reasonable and consistent.
JLT now looks forward to working with employers and TPR to achieve consistent and sustainable outcomes for sponsors and scheme members.
The Pensions Regulator has gone on record to agree that gilt yields are currently depressed as a result of quantitative easing (QE). Such a statement may be surprising as this has now become something of a political issue with both Steve Webb and Mervyn King denying a link between QE and pension costs within the last few weeks.
The Pensions Regulator quite rightly points out that the rules trustees and sponsors have been working to are already flexible enough to cope with the current state of affairs. The Pensions Regulator should be lauded for having drawn together fundamental principles, which are now standing the test of extreme market conditions.
The real, practical purpose of the funding valuation is to set sponsor contribution rates. There are already perfectly sound ways of designing funding strategies which do not radically alter the sponsor’s cash commitments.
It is also encouraging that The Pensions Regulator reaffirms the need to adopt rates which are affordable. It fully recognises the need to allow sponsors to remain in business and capable of providing financial support to their pension schemes over the longer term.
The Pensions Regulator does raise a challenge over use of sponsor resources for dividend payments rather than cash funding of the pension scheme. However, sponsors and trustees are guided to treat the competing demands on sponsors equitably. Equitable does not mean equal; The Pensions Regulator will have chosen its language carefully.
The statement from The Pensions Regulator about scheme funding in these difficult financial times makes it clear that trustees need a cohesive financial management plan that links funding with investment strategy and the employer’s covenant. Arguably, this will place a burden on many trustee boards, but actually TPR has, in my view, struck the right balance between the relevant regulations and pragmatism.
Currently, pension schemes face the prospect of falling within the ambit of Solvency II. Those who have argued against the directive applying to pension schemes must understand that the corollary of this is that governance needs to be rigorous.
Although it may impose a burden on pension trustees, the statement provides a helpful framework for trustees to work within and enter into dialogue with their sponsoring employer in the context of competing calls for cash within their organisation.