The Pensions Regulator (TPR) has issued its Annual Funding Statement for defined benefit schemes (the Funding Statement). The Funding Statement identifies some of the key issues facing schemes with valuations in the period 22 September 2019 and 21 September 2020 (Tranche 15) (Tranche 15 Valuations).
In the Funding Statement, TPR recognises the need for trustees and employers to work together to manage the impact of COVID-19 but TPR remains focused on ensuring that trustees and employers develop a long-term funding objective. TPR also highlights the importance of integrated risk management and the need to implement contingency arrangements already in place, where possible. Understanding the covenant is crucial and the Funding Statement includes a reminder about the importance of understanding the potential impact of the different possible outcomes in relation to Brexit.
1. COVID-19 - Co-operation is KEY
TPR recognises that these are very challenging times. All schemes that have been impacted by COVID-19 should read TPR's COVID-19 guidance. TPR will issue further guidance as necessary. In particular, TPR is considering issuing further guidance in the autumn. TPR acknowledges that the best support for a pension scheme is a strong employer. Trustees and employers need to work together during what is a very challenging time for many businesses to manage the immediate impact of COVID-19.
2. Long-term focus
Paying the promised benefits is the key objective for all schemes. Trustees should look ahead and set clear plans for how this objective will be delivered and managed, taking a view on the employer's covenant, within an integrated risk management framework. Trustees with a long-term funding target already in place should continue to focus on that, with suitable short-term modifications. Those schemes without a long-term funding target in place are encouraged to set one.
3. Funding and the specific valuation date
TPR acknowledges that this year more than others the exact valuation date will affect a scheme's funding position. However, key decisions about the impact of COVID-19 on covenant assessments, affordability, scheme funding positions and designing recovery plans will still need to be taken in order to finalise Tranche 15 Valuations.
4. Employer covenant and covenant leakage
TPR expects trustees to assess employer covenant with the aid of specialist advice where necessary and to monitor it more frequently and with increased scrutiny, until such time as there is greater covenant visibility. TPR also warns trustees to be extra vigilant about covenant leakage, in particular where they have agreed to a COVID-19 scheme funding concession based on the employer's affordability.
What does the Funding Statement mean for trustees and employers?
The Funding Statement sets out the points which trustees and employers should consider, along with the existing Defined Benefit (DB) funding legislation, when carrying out Tranche 15 Valuations. It also includes some points that are relevant to all trustees and employers.
Long-term funding objectives, IRM and scenario testing
A key theme is that trustees should not lose sight of their long-term funding target (LTFT) among the short-term volatility consequent to the COVID-19 pandemic. Any changes in pension deficits should be recognised, with the intention that such deficits are recovered, while at the same time focussing on the affordability and sustainable growth of the employer.
TPR expects trustees to focus on the integrated management of three broad areas of risk: the ability of the employer to support the scheme, the investment risks, and the scheme's funding plans. An integrated risk management (IRM) framework can help schemes to fulfil the requirement to have a specific long-term funding strategy, which is set out in the Pension Schemes Bill.
TPR also encourages trustees to use scenario planning as part of their IRM framework and points out that many employers will already do this for their own business planning.
Effective date of Tranche 15 Valuation critical to funding snapshot
This year more than others the exact valuation date will affect a scheme's funding position. For schemes with a 31 December 2019 valuation date, there was a general improvement in funding levels compared with three years previously. For those with effective dates at or near 31 March 2020 (a little over 50%), funding positions were very variable.
In recent years, many schemes have de-risked as they have become better funded and more mature; having less exposure to equity markets and good levels of hedging. For these schemes, the sharp drop in UK equities, the fall in global equities, gilts yields and the inflation expectations of investors in the gilts market at 31 March 2020 have had less impact. Such schemes should remain focused on their LTFT, making suitable short-term modifications.
A smaller proportion of schemes experienced a sharp fall in funding levels because they were heavily exposed to equities and not sufficiently hedged against interest rate risk. If an IRM framework exists, these schemes should have contingency plans in place, which should be implemented if possible. If this is not the case, TPR says that trustees and employers will need to consider how far they have strayed from their longer-term objective and develop shorter-term investment and funding strategies to put them back on course, and be prepared to evidence this.
Post-valuation experience and changing the valuation date
Given the significant changes in market conditions, schemes with valuation dates around 31 December 2019 (or earlier) should consider taking account of post-valuation experience in their recovery plans if the scheme's assets and liabilities and/or the employer covenant have been impacted; even if they are well advanced with their provisional valuation results. TPR recognises that some schemes will be close to completing valuations and has said that it does not expect valuation assumptions to be revised to take account of post-valuation experience. However, post-valuation experience should be considered when preparing the recovery plan.
Those with valuation dates on or around 31 March 2020 may be considering (or are being requested to consider) bringing forward the effective date of their valuation to a date when conditions were considered more normal (e.g. December 2019). Trustees who take this decision can expect TPR to question their reasons for the change. TPR says that trustees should think very carefully why this would be in the best interest of their members. Trustees will need to obtain and consider legal and actuarial advice, and take account of changes in the investment markets and employer's covenant since the new date of the valuation.
Calculating technical provisions, agreeing recovery plans and affordability
TPR expects schemes to proceed with as much of the preliminary valuation work as possible but acknowledges that March and April 2020 valuations will be particularly challenging. It might, therefore, be reasonable to delay taking decisions about technical provision assumptions.
Trustees might need to work with a preliminary set of results. These will then be refined during the valuation period as clarity emerges. This could be necessary if the trustees do not yet have sufficient information to form a reliable view on long-term future returns from their scheme's investments or the employer's covenant and affordability.
Recovery plans should balance visible affordability, while maintaining fair treatment and balancing the sustainable growth of the employer, with contributions linked to well-defined triggers (such as incremental increases in contributions), which track corporate health recovery, and/or additional contributions based on appropriate triggers (such as free cash flow and payments to other creditors or investment performance).
The Funding Statement makes it clear how important it is that trustees obtain appropriate covenant advice. Employers will be affected by the COVID-19 pandemic to varying degrees. Some businesses will recover more quickly than others and some may also suffer additional uncertainty as a result of the UK's departure from the EU. All of this will need to be factored into any covenant assessment.
Trustees should be prepared to carry out additional due diligence on the employer's covenant in accordance with TPR's COVID-19 guidance. TPR expects the frequency and intensity of monitoring of employer covenant to be significantly increased until covenant visibility and strength is restored. Where covenant is complex, deteriorating, or where the scheme has a high degree of reliance on it, the assessment of covenant and employer affordability may require specialist advice. If trustees undertake their own covenant assessment, TPR states that this should only happen if they have sufficient expertise and trustees should keep a full audit trail and be mindful of potential conflicts of interest.
Contingency plans, ideally drawn up with the employer, should include agreed trigger points and specified actions so that where monitoring identifies adverse changes in the covenant or a scheme's funding level deteriorates by more than a specified level for example, trustees can react quickly. Trustees should be able to demonstrate and share relevant documentation with TPR to evidence that these interactions have taken place.
Covenant leakage is complex and TPR expects trustees to be alert to this. Obvious examples of covenant leakage are excessive executive remuneration and payment of shareholder dividends but it can also arise from inter-company arrangements such as lending. These arrangements can be challenging for trustees to understand without taking professional advice. Where an employer is seeking a long recovery plan, say because of limited affordability (or a suspension of deficit repair contributions), trustees should seek appropriate legally enforceable agreements to prevent covenant leakage to the wider group. Compensation should also be sought for the resulting deterioration in covenant - such as security over employer assets, or 'upside sharing mechanisms' in the recovery plan itself - so that, in the event of employer performance improving in the future and/or dividend payments recommencing, the scheme can receive increased contributions.
Trustees should have a full audit trail of their considerations and decisions, and be ready to share their detailed documentation with TPR, as well as their reasons for not taking professional covenant advice.
What TPR expects of trustees
The tables that featured in the 2019 Annual Funding Statement have been reproduced in this year's funding statement following feedback that these were very helpful. These set out key risks and TPR's expectations, depending on scheme and employer characteristics. There are remarkably few changes to the messages in light of the significantly different current conditions caused by COVID-19.
Trustees should decide how, if at all, their covenant has changed because of COVID-19, how it could be impacted by Brexit, and how good their funding position is relative to their long-term funding target in order to find the table closest to their situation. Their advisers can assist in determining the broad position of their scheme within the relative spectrum.
What trustees can expect of TPR
TPR will risk assess valuation submissions in a proportionate way and its focus will be on understanding and supporting trustees in responding to the impact of COVID-19. TPR will be ensuring that the easements it has announced are not abused and trustees and employers should be fully prepared to justify and explain their approach with supporting evidence.
TPR reminds trustees that its powers include the scheme funding power to direct how a scheme's technical provisions should be calculated and how (including over what period) its deficit should be funded.
Next steps for trustees
- Trustees should take a long-term view and act in members' best interests, which TPR recognises will usually involve supporting the existence of a healthy employer.
- Trustees should decide how, if at all, their covenant has changed because of COVID-19, how it could be impacted by Brexit, and how good their funding position is relative to their LTFT. Where trustees do not have a LTFT they should work with the employer to agree one together with an IRM framework and a contingency plan.
- Trustees should apply their IRM and consider scenario planning and the possibility of aligning pension scheme experience with any modelling already carried out by the employer for its business.
- Preliminary valuation results should be used to progress the valuation and trustees should consider delaying setting technical provisions until there is greater clarity on the impact of COVID-19 on employer covenant and scheme investments. Trustees should also consider if post-valuation experience should feature in recovery plans, and be prepared to explain any changes to the valuation date or agreement to any other COVID-19 related concessions, such as the deferral of deficit repair contributions.
- Trustees should be vigilant and monitor covenant leakage to ensure that the scheme does not lose out as a result of any agreement to greater flexibility in the valuation. Appropriate mitigation should be sought and, if value is not readily available to the scheme, the recovery plan should reflect this.
- Trustees should be prepared to undertake additional due diligence on employer covenant, monitoring it more closely and frequently and should also consider whether specialist advice is required.
- Trustees should keep a full audit trail of their decisions and be prepared to share supporting evidence with TPR.