Introduction
The Pensions Regulator (TPR) published its 2022 Annual Funding Statement on 27 April 2022. The statement is for trustees and sponsors of Defined Benefit (DB) pension schemes and is particularly aimed at schemes with actuarial valuations between 22 September 2021 and 21 September 2022 (‘Tranche 17’) as well as those reviewing their funding and risk strategies.
Some of the key points are summarised below:
Current economic climate
TPR acknowledges the challenging economic background that trustees are currently facing with high inflation, high energy prices, rising interest rates and slowing economic growth all potentially impacting pension scheme funding and employer covenants. It also highlights the significant continuing uncertainty in global economies in light of the Ukraine conflict and the ongoing effects of the COVID-19 pandemic as well as the lingering effects of Brexit.
All these factors mean that trustees should continue to focus on robust employer covenant assessments, noting that certain sectors will see direct impacts from these events whilst other employers may be affected indirectly, for example, through supply chain issues. An open dialogue between the sponsor and trustees is seen as key to achieving this.
Funding positions
The majority of valuation dates in this tranche fall on or around 31 December 2021 or 31 March 2022. At both dates, TPR expects schemes to show improved funding levels when compared to three years ago largely driven by favourable investment conditions. However, the position for individual schemes will vary depending on a number of factors, in particular the level of hedging within the investment strategy.
Covenant considerations
Market volatility remains high with the major events mentioned above impacting all businesses in different ways. TPR accepts that it is becoming more difficult for trustees to differentiate between the impact of any single event versus another, but advises trustees to focus on the overall impact, with independent specialist advice being strongly recommended where accessible. It suggests that companies are likely to fall into one of the three following categories:
- Current market events have had a limited impact on the business, with no balance sheet weakening and cash flow remaining strong.
- Current market events have had a material impact, but trading has recovered or is recovering strongly, or some impact is anticipated but is expected to be short-lived.
- The impact of current market events continues to be material. Recovery could take years, or may never happen. Short-term affordability is stressed and the balance sheet has weakened.
Shareholder distributions and covenant leakage
This remains a major issue for TPR; it highlights that there has been an increase in employers returning cash to shareholders through dividends and share buybacks. It encourages trustees to monitor this and consider whether the pension scheme is being treated fairly compared to other stakeholders. In particular, TPR reminds trustees of three key points from its 2019 annual funding statement:
- Where dividends and other shareholder distributions exceed deficit repair contributions (DRCs), TPR expects a strong funding target and recovery plans to be relatively short.
- If the employer is tending to weak or weak, TPR expects DRCs to be larger than shareholder distributions unless the recovery plan is short and the funding target is strong.
- If the employer is weak and unable to support the scheme, TPR expects the payment of shareholder distributions to have ceased.
Actuarial and investment considerations
Interest rates
Interest rates and gilt yields have risen significant throughout the first part of 2022, however, they remain exceptionally volatile. The impact of this rise will vary from scheme to scheme but trustees should be mindful of collateral calls for schemes with significant levels of geared hedging. Liquidity of investments therefore remains a key consideration.
Inflation
Current levels of inflation are very high and will impact schemes in different ways depending on their benefit structure and investment strategy. Trustees should consider the impact of current levels of inflation on benefit increases and salary increase assumptions.
Over the longer term, TPR again references the UK Statistics Authority’s plan to align the Retail Prices Index (RPI) with the Consumer Prices Index including owner-occupied housing costs (CPIH) from 2030. Trustees should carefully consider the impact of this on their inflation assumptions both pre and post 2030.
Rises in longer term inflation expectations will, all else being equal, lead to an increase in liabilities for most schemes. Adjustments to market-implied inflation measures (e.g. through an inflation risk premium) remain reasonable but TPR emphasises that it expects these to be consistent with the inflation exposure within the scheme’s investment strategy.
Mortality
TPR recognises that there are differing views on the impact of the COVID-19 pandemic on mortality, and the long-term effect is likely to take more time to become apparent. It notes the core parameters of the Continuous Mortality Investigation (CMI) model continue to make no allowance for 2020 or 2021 data and allowing for this increased mortality experience should be considered carefully. In particular, TPR suggests that, where trustees feel that a change to their mortality assumption is appropriate and justifiable, any reduction in liabilities as a result of such a change should not exceed 2%.
Long term funding target (LTFT) and journey plans
TPR reminds trustees that the Pension Schemes Act 2021 will make it a legal requirement for scheme to set a specific LTFT and they should consider taking steps now to agree a LTFT with the sponsor and set an appropriate journey plan.
TPR also notes that it may be many years before the scheme reaches its LTFT and trustees should be mindful of the extent of their reliance on the employer covenant over time. Trustees should therefore focus on both the short and longer term risks when discussing employer covenant with management.
Trustees should undertake stress testing or scenario planning to understand the impact on the covenant and the scheme’s funding of possible future economic environments.
TPR highlights that schemes that are now fully funded (or close to fully funded) on a technical provisions basis should review their liquidity needs in the light of a reduction in employer contributions and factor this into their LTFT and investment strategy.
The 2022 Annual Funding Statement can be found here.
If you would like any further information in relation to the above, please get in touch with your usual Quantum Advisory contact or email us at info@qallp.co.uk