What employers need to know about TPR's annual funding statement
The Pensions Regulator recently issued its Annual Funding Statement (AFS) which increased the pressure on defined benefit pension scheme sponsors. The AFS highlights some of the key principles from the defined benefit (DB) funding code and provides guidance for schemes undertaking 2016 valuations.
It contains clear statements on what it expects from trustees that are likely to sway their actions. Trustees and employers need to be aware of these issues, understand the relevance to their circumstances and plan their response.
So what are the key points?
Expected worsening of funding positions due to market movements
Low interest rates continue to inflate pension scheme liabilities and put pressure on balances sheets and cash contributions. The Pensions Regulator expects that most schemes with valuations this year will have lower expected asset returns than previously, leading to higher pension scheme liabilities.
The assets commonly held by pension schemes have performed strongly compared to other periods (e.g. UK equities returned 23.4% in the three years to 31 December 2015, pg 9 of AFS) but these returns are unlikely to offset the increases in liabilities and, so despite, this the overall impact will be bigger deficits and higher contributions.
Gilt yield reversion hasn’t materialised
Some trustees and sponsors argued at their last valuation that gilt yields were artificially suppressed and so used assumptions that allowed for reversion to a more typical long term rate. Three years later this reversion has not materialised and the Pensions Regulator suggests that these schemes “should consider whether they need to implement any of the contingencies they have in place”. Contingencies are likely to involve either more cash or some other security from the employer.
Removing any allowance for gilt yield reversion could significantly increase the liabilities for those that used this argument. Retaining an allowance is going to be significantly harder to justify. Sponsors might need to look elsewhere, for example to increase expected returns through more risk-efficient investment strategies.
Higher contributions where affordable
The Pensions Regulator expects that, in general, companies will be able to afford higher contributions than they did three years ago. This is based on their analysis of dividend payments, profitability and the balance sheets of sponsoring employers.
Where the deficit has increased and a company can afford to, the Pensions Regulator expects trustees to seek higher annual contributions rather than an extension to the current recovery period.
These comments will support trustees in pushing for shorter recovery periods with higher contributions from their sponsors. Companies will be in a delicate position where they will want to appear both secure and cash poor in order to get both favourable assumptions in calculating the deficit as well as favourable terms for the recovery plan. Increasingly, we are seeing employers using covenant advisors to help them build and communicate their case to the trustees for covenant strength and affordable funding plans.
Security as an alternative to cash contributions
Where a company cannot afford higher contributions the Pensions Regulator expects trustees to have an open conversation and consider what alternative options exist. Some of the alternatives that could be considered are guarantees from other companies, security over assets and contingent funding agreements.
Alternatives to cash could be more attractive to the company sponsor and, to take best advantage of this, companies should be prepared for this conversation by knowing what it can offer and what it wants in return.
Pension flexibilities: Justifying an allowance for transfers out
This typically results in a release of some funding reserve for that individual. Increased flexibility for DC pensions has led some to believe that more DB members will transfer-out in order to take advantage.
The Pensions Regulator has pointed out that there is currently little evidence to support changing assumptions to reflect this possible change in behaviour. If individual schemes can demonstrate a change in behaviour they could potentially introduce an allowance for transfers out. However the majority of schemes are unlikely to be able to do this at present.
A blip in mortality improvement
There has been a long trend in mortality assumptions towards higher life expectancies. However the 2015 tables from the Continuous Mortality Investigation (CMI) has shown a reduction in life expectancies compared to 2014. The Pensions Regulator acknowledges this and believes it is reasonable for Trustees to use the 2015 tables, however they point out that there is little evidence of any change to the long term trend.
So there may be a small gain from the 2015 table, but given the last valuation was three years previous, this is likely to be wiped out by the increases in life expectancies in the other two years. As the Pensions Regulator does not see any change in the long term rates of improvement, the overall impact is likely to be a higher deficit due to mortality updates, albeit smaller than you might have expected in 2014.
Setting mortality assumptions should be a considered process rather than a roll forward of previous assumptions. Thinking and tools such as postcode mortality investigation have moved on in recent years, so sponsors will want to take a fresh look at their options.
Setting your own agenda
The annual funding statement is a helpful insight into the Regulator’s current thinking. Trustees might feel uneasy straying too far from the Regulator’s signed path, but it’s worth remembering that every scheme and every sponsor is different. There are a variety of appropriate routes that you can take.