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Regulator publishes its annual funding statement 2021

Our viewpoint

News Alert 2021/02

At a glance

The Pensions Regulator has issued this year’s DB funding statement.  As in previous years it sets out the Regulator’s key messages for trustees and sponsors who are undertaking valuations at the current time.  This second Covid-19 influenced funding statement continues with a number of the themes in last year’s statement, focussing once more on covenant issues, but with the benefit of being one year on and having far less of an emergency feel to it.

Key Actions

Trustees and sponsors, especially those currently carrying out or approaching a valuation

  • Read the statement, establish which of the groups described in the tables your scheme most closely resembles and assess whether the statement affects the current approach being taken in relation to covenant, investment and funding issues.
  • If not already done so, draw up a long-term goal for paying the promised benefits, set a consistent long-term funding target (LTFT) in relation to this goal, and establish a journey plan for progressing to the LTFT, ensuring that investment and funding strategies in the interim period are aligned.
  • If not already done so, assess the impact that Covid-19 (and Brexit) has had on covenant and consider the implications for funding and investment.

The Detail

On 26 May 2021 the Pensions Regulator issued its annual funding statement, aimed at trustees and sponsors of DB schemes.  The statement is focussed on schemes with valuations with effective dates between 22 September 2020 and 21 September 2021 as well as schemes undergoing significant changes (for example, where the employer covenant has been impacted by Covid-19 and/or Brexit) that require a review of their funding and risk strategies.

The statement comes ahead of the Regulator’s new Code of Practice on funding defined benefits and the new powers that the Regulator will be getting in the scheme funding arena following the enactment of the Pension Schemes Act 2021.  Although the statement is inevitably very much influenced by how the new funding regime is intended to operate, the Regulator confirms that all valuations subject to this statement “will be regulated according to the requirements of the existing legislation and guidance that is currently in force”.

Even longer than last year’s statement, the bulk of the document comprises tables setting out a segmentation of DB schemes containing the key risks that trustees and employers should focus on and actions they should take depending on the characteristics of the scheme and sponsor.  The tables are consistent with those in last year’s statement with no material changes.

1. Scheme specific considerations

After saying a few words about how funding positions are likely to have developed, the statement turns to a number of considerations for schemes currently undertaking a valuation, as follows:

Actuarial assumptions and scheme demographics

The Regulator points to the importance of understanding the key valuation assumptions used, through considering a range of possible outcomes when considering the technical provision assumptions to adopt.  The benefits of scenario planning are highlighted.  Turning to some specifics:

  • Inflation – the proposed alignment of the RPI with CPIH from 2030 means that trustees will have to choose their inflation assumptions carefully both pre- and post-2030
  • Mortality – the differing views on the impact the pandemic will have on the mortality experienced by schemes is recognised and some suggestions are made as to how trustees may wish to proceed at the current time. In particular, the Regulator expects trustees to justify any material weakening of their mortality assumption, with contingency plans put in place in case the assumption of continued higher mortality rates does not materialise in practice
  • Post valuation experience – trustees are reminded that they can consider taking into account post valuation experience, but this should not be used as an opportunity to select the most favourable date for agreeing the deficit recovery plan. In addition, factoring in favourable post-valuation events should usually result in recovery plan lengths shortening, rather than annual deficit contributions reducing

Investment considerations

  • Liquidity – given that the majority of schemes are now closed to new members and are maturing, trustees should actively monitor and mitigate their liquidity risks. The analysis should be proportionate to the scheme but could include carrying out “stress testing” of both cash requirements and realisable asset values
  • Cessation of banking benchmarks for cash-like investments – where schemes use a swaps-based discount rate in their valuations, they should ensure there is no linkage to either LIBOR or its European equivalent as both measures are being phased out

Covenant considerations

  • Covenant assessments – the importance of obtaining independent specialist advice to support covenant assessment is discussed in the context of the impact of Covid-19 on employers being varied, with the employer's business sector being a key factor. Specific situations are listed where obtaining an independent covenant assessment is particularly important with these including where the covenant is complex or deteriorating and where the scheme has a high degree of reliance on the covenant
  • Covid-19 – the Regulator envisages that the impact the pandemic has had on scheme sponsors will fall under one of three broad categories – limited impact on the business, material impact initially but trading recovering strongly and continued material impact. Trustees are asked to take a view on this, and to consider undertaking stress testing or scenario planning which reflects possible future economic environments.  Employers are asked to provide financial projections and updated business plans to enable trustees to assist.  Where Covid-19 continues to have a material impact on the employer, trustees will need to decide whether there has been a material deterioration in the employer’s covenant, they should not assume there will be a full recovery in covenant support without good justification and should review the funding and investment strategies.
  • Brexit – for some sponsors the changes in trading conditions following the UK’s departure from the EU may have heightened uncertainty over the covenant and in these situations trustees need to gain a full understanding of the position.
  • Affordability and DRCs – where external developments have had a limited impact on the employer’s business, trustees should adopt a ‘business as usual’ approach to setting recovery plans – so DRCs should not be reduced or recovery plan end dates extended. Where the initial impacts of Covid-19 were material but trading is recovering, trustees should carefully consider any requests to accept a lower level of contributions – but only for the short term and with higher contributions in subsequent years limiting any extension to recovery plan end dates.  Where employers continue to request support (or indeed a change to contribution structures for other reasons) from the scheme through DRC deferrals and/or lower ongoing DRCs as part of a revised recovery plan, trustees should obtain suitable mitigations.
  • Covenant monitoring and contingency plans – the Regulator welcomes the increased frequency and intensity of covenant monitoring that it believes most trustees have adopted recently and asks that this continues. The need to have in place contingency plans is stressed once more, so that trustees can react appropriately where the monitoring identifies adverse changes in the covenant. Trustees are encouraged to discuss key risks and potential options for action with the employer and should also be able to demonstrate that these interactions have taken place.
  • Corporate transactions – the Regulator expects that there will be an increase in the level of corporate activity as the recovery from Covid-19 progresses. Trustees need to be prepared and ready to act in the event of any corporate activity, should take a rigorous approach to assessing the impact of any corporate transactions and to negotiate mitigation (where relevant) to protect the interests of members and ensure fair treatment with other creditors.  Where the trustees are working through a valuation process they could use this as leverage to obtain mitigation for detriment caused by a corporate event independently of the valuation.  Where new procedures for distressed companies, as a consequence of the Corporate Insolvency and Governance Act 2020, are in play trustees should seek specialist advice from a restructuring professional since the challenges faced will be case-specific.

Our viewpoint

Covenant remains uppermost in the Regulator’s mind, as it will have done for trustees over the last year. Although the messages are somewhat different this year and there are more of them, they are consistent with recent regulatory guidance in this area, such as that on covenant leakage, dealing with distressed sponsors, integrated risk management and setting longer term objectives.

The Regulator’s focus is now on the recovery, which for some sponsors is likely to be a bumpy ride. There is a continued need for trustee vigilance in the face of economic uncertainty, with encouragement to consider a number of different forecast scenarios when examining the future direction of travel for covenant strength and affordability.

2. Managing risks

As in previous years the Regulator sets down a clear expectation that trustees should focus on the integrated management of the risks arising from the employer covenant, investment and funding plans, asking trustees to develop an IRM framework and associated governance providing them with useful information for their decision-taking. 

The statement then turns to four issues:

  • Climate change – trustees are asked to consider the impact of climate change on all three elements of an IRM approach. The Regulator expects compliance by trustees “with the basics of climate change” in relation to their statement of investment principles and associated implementation statement
  • Long-term funding targets – consistent with last year’s statement, the Pension Schemes Act 2021 and the new funding code of practice consultation, the Regulator encourages all DB schemes to set a long-term funding target (LTFT) for a level of assets the scheme would need by the time it has reached significant maturity, such that it allows the scheme to reduce dependency on the employer.  The Regulator also encourages investment and funding strategies in the interim to be aligned to the LTFT via journey plans
  • Scheme maturity – the Regulator expects scheme maturity issues to assume greater significance for setting funding and investment strategies as the majority of schemes are now closed to new members
  • IRM and governance – the Regulator points to the 2018 governance regulations which are to be implemented via parts of a new single Regulator code of practice, expected to be in force by late 2021. New requirements will include that all occupational schemes with 100 or more members carry out and document their first Own Risk Assessment (ORA) within 12 months.  It is suggested that documenting key risks at the present valuation and how they are managing them within an IRM framework should make this task easier.

Our viewpoint

No surprises here and a useful reminder that the risks to assess within the IRM framework should include those relating to climate change, and the framework itself will shortly be expanding.

3. What to expect from the Pensions Regulator

The Regulator starts this section by reminding trustees that they are the first line of defence for savers and their pension schemes and promising engagement with schemes if they have concerns over corporate distress, to ensure that their guidance is being followed.

The Regulator reminds trustees that each valuation submission it receives is risk-assessed in a proportionate way and that “Trustees and employers should be fully prepared to justify and explain their approach with supporting evidence”.  It then goes on to remind everyone of the Regulator’s current suite of powers in the DB funding space and that new powers, as a result of the Pension Schemes Act 2021, are on their way.

4. Key risks to focus and take action on

Once more the Regulator provides a comprehensive set of tables in which it sets out its expectations across covenant, investment and funding, which differ according to the characteristics of the scheme.  There are five scheme types as follows:

 

Covenant

Funding

A

Strong or tending to strong

Funding position considered to be strong, technical provisions are strong and recovery plan is shorter than average (less than 7 years)

B

Strong or tending to strong

Technical provisions are weak and/or recovery plans are long (more than 7 years)

C

Weaker employer with limited affordability

Scheme funding on track to meet long-term funding objective, technical provisions are strong and contributions are reducing deficits at a slower but affordable pace

D

Weaker employer with limited affordability

Technical provisions are weak and/or recovery plans are long (more than 7 years)

E

Weak employer unable to provide support

Stressed scheme with limited or no ability to use flexibilities in the funding regime

each of which are further sub-divided according to whether the scheme is relatively immature or relatively mature.

The tables themselves are consistent with those in last year’s statement with no material changes.  The Regulator specifically asks trustees to decide whether, if at all, the sponsor’s covenant has changed as a result of Covid-19 and Brexit, where broadly they are in the maturity spectrum, and how good their funding position is relative to their long-term funding target.

Having done this, trustees are asked to prepare their recovery plan to balance affordability with contributions linked to well defined triggers, contingency plans and other protections for member security, as suggested earlier in the statement.

In conclusion

This latest statement delivers a useful insight into the Regulator’s latest thinking in a number of areas that have a bearing on scheme funding and should prove to be valuable reading for those engaging in valuations at the present time.  However, there is little that is genuinely ‘new’ in this statement.  Those who have been keeping abreast of developments over the last year in the world of scheme funding, investment and covenant should be able to take these insights and expectations in their stride.

This News Alert does not constitute advice, nor should it be taken as an authoritative statement of the law. If you would like any assistance or further information on the issues raised, please contact the partner who normally advises you at LCP via telephone on +44 (0)20 7439 2266 or by email to enquiries@lcp.uk.com.

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