On 27 April 2022, The Pensions Regulator (TPR) published its latest annual DB funding statement, which is relevant to trustees and sponsors of all private sector defined benefit (DB) pension schemes, but will be of particular interest to those undertaking an actuarial valuation with an effective date between 22 September 2021 and 21 September 2022 (referred to as ‘T17 valuations’).
The statement recognises that pension scheme funding and employer covenants could be affected by the current economic background of slower economic growth and increases in price inflation, energy prices, and interest rates, combined with the implications of the ongoing conflict in Ukraine, COVID-19 and Brexit.
The statement includes a reminder that the current funding regime applies until all the new legislation and the revised DB funding code come into force. TPR expects to launch its second consultation on the new code later in 2022 and will therefore regulate all T17 valuations in line with the existing legislation and guidance. The consultation will also set out TPR’s proposed changes to its covenant guidance and provide more detail on how to treat guarantees for scheme funding purposes. It will also provide more information regarding environmental, social and governance and how this can be factored into the covenant.
TPR notes that long-term interest rates have risen in recent months and gilt yields continue to be volatile, but the effect on scheme funding levels will vary from scheme to scheme depending on the investment strategy and level of hedging in place.
Trustees should give careful consideration to the effect that increases to the rates of published price inflation in recent months and any changes in long-term inflation expectations have on the scheme’s financial position. Any adjustments made to market-implied inflation measures (such as allowing for an inflation risk premium) are expected to be consistent with the scheme’s exposure to inflation within its investment strategy.
The statement recognises the scope for differing views on the effect of COVID-19 on mortality for pension scheme members and the potential for different approaches. However, TPR acknowledges that some schemes may now feel that changes to mortality assumptions are justifiable but cautions that it expects any reduction in liabilities to be no more than 2% unless the change is accompanied by strong supporting evidence.
TPR’s expectations for recovery plans depend on how the sponsor has been affected by events such as COVID-19 and Brexit:
TPR notes that favourable investment conditions over the last three years may mean that for many schemes the funding position is now ahead of plan, but with a wide dispersion of outcomes depending on the scheme’s investment strategy and hedging levels.
Where schemes are now fully funded on a technical provisions basis trustees should ensure that their journey plan for meeting any longer-term objectives remains appropriate and continue to focus on managing risks, for example through the use of contingent contributions or funding arrangements. These mechanisms could also address employer concerns on trapped surplus. Schemes that have moved into surplus on a technical provisions basis should consider how their liquidity needs will change when deficit contributions cease.
TPR repeats many of its messages on covenant assessment from recent annual funding statements, but with additional emphasis on considering how market events could affect the employer’s business. Trustees are encouraged to consider seeking independent specialist advice where appropriate.
Trustees should undertake stress testing or scenario planning to understand how possible future economic environments affect the covenant, including prolonged high inflation and interest rate scenarios and any impact from the ongoing conflict in Ukraine, and consider these in the context of any expected impact on the scheme’s assets and liabilities.
TPR notes that it has seen a recent increase in employers returning cash to shareholders through dividends and share buybacks. TPR expects trustees to remain vigilant and consider whether the scheme is being treated fairly; its minimum expectations remain consistent with the pre-pandemic position:
Trustees should also be alert to other forms of covenant leakage that could reduce the employer’s ability to support the scheme, including cash pooling arrangements, group trading arrangements and management fees.
Trustees are encouraged to consider building further protections into valuation discussions, such as dividend sharing mechanisms or negative pledges.
Trustees should be prepared and ready to act in the event of corporate activity, which is expected to increase as the recovery from COVID-19 progresses. Trustees should take a rigorous approach to assessing the impact of transactions and negotiate appropriate mitigation for any detriment caused, independently of the valuation.
TPR suggests that trustees should consider adopting a long-term funding target (LTFT) ahead of this becoming a legal requirement once the Pension Schemes Act 2021 is implemented and incorporating this into their journey plan.
TPR continues to expect trustees to focus on integrated risk management across funding, investment and covenant and emphasises the importance of monitoring the funding position and key metrics, with contingency plans in place for when threshold limits for these metrics are breached.
Trustees should consider the extent of their reliance on the employer covenant over time. Where there are concerns over longer-term risks to the covenant, trustees are encouraged to consider alternative funding and investment strategies that place less reliance on the employer’s support in the longer-term and to consider requesting downside protection from the employer to manage this risk.
As in last year’s statement, TPR has included a series of tables providing additional guidance on the key risks that trustees and employers should focus on and expected actions, depending on the sponsor’s covenant strength, the scheme’s funding and investment characteristics and its maturity. These tables are substantially unchanged from last year’s statement, beyond references to shorter recovery plans being changed to “around six years” compared to seven years.
