Introduction
The Pensions Regulator (TPR) published its 2023 Annual Funding Statement on 27 April 2023. 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 2022 and 21 September 2023 (‘Tranche 18’) as well as those reviewing their funding and risk or those receiving requests for reduced contributions, amendments to contingent asset arrangements, and proposals for other uses of surplus.
Some of the key points are summarised below:
Funding Regime
TPR expects the new funding code to come in to force around April 2024, reiterating that the current funding regime (as set out in Part 3 of the Pensions Act 2004 and TPR’s current DB funding code and guidance) applies until then.
Funding Positions
The majority of valuation dates in this tranche fall on or around 31 December 2022 or 31 March 2023. At both dates, TPR expects schemes on aggregate to show improved funding levels when compared to three years ago, largely driven by investment out-performance on return-seeking assets and rising interest rates. Many schemes are now expected to be in a surplus on their buy-out position. However, the position for individual schemes will vary depending on a number of factors, in particular the level of hedging within the investment strategy.
TPR expects the speed and magnitude of the decreases in assets and liabilities of schemes as a result of rising interest rates to have surprised many, commenting that long-term objectives set in an era of low interest rates may need to be reviewed.
Current Economic Climate
While funding positions may be relatively healthy, TPR highlighted the need to recognise the economic uncertainty that may continue to impact funding, investments and employer covenant in different ways, including:
- further increases in interest rates
- high rates of inflation
- volatile commodity and energy prices
- the potential for ongoing or new geopolitical instability and/or conflict
Rethinking strategies
Funding Considerations
For any schemes that haven’t agreed a long-term funding target (LTFT) yet, this should be seen as a priority.
TPR has provided specific guidance based on schemes’ different funding positions, separated into 3 groups.
Group 1 – Where funding level is at or above buy-out
Consideration should be given to whether buy-out is the best way forward. This would involve:
- Assessing the provision of the Trust Deed and Rules and any guidance this might provide
- Seeking advice: investment, legal and actuarial
- Consulting the employer
TPR notes that
- Buy-out may not be appropriate for all schemes
- Capacity issues might mean buy-out is less viable in the short-term
- The process is lengthy
- Trustees should understand the risks and benefits, along with their duties.
Group 2 – Where funding level is above technical provisions but below buy-out
Trustees should consider the appropriateness of the long-term funding objectives in place and the timescale set out for reaching them.
It would be seen as good practice to start aligning investment and funding with the key principles of the draft funding code.
Group 3 – Where funding level is below technical provisions
The initial focus should be to bridge the funding gap.
Technical Provisions (“TPs”) should be reviewed to make sure they align with their LTFT and ensure any risk taken is supported by the employer covenant.
Deficits should be recovered as soon as the employer can reasonably afford.
Investment Considerations
Due to the rise in interest rates, some scheme’s investment holdings will have diverged from their target allocations. This along with the changes in funding positions will likely require many schemes to need to review their investment strategy.
Where funding positions have improved a lower rate of return will be needed to reach long-term objectives and therefore there should be scope to de-risk or de-leverage liability driven investments.
Events in 2022, particularly those seen in in the processes for collateral payments in LDI investment strategies highlighted the need to consider operational risks and the requirement to suitably manage illiquid asset holdings. Where significant illiquid asset are held Trustees should seek advice.
Some schemes may have been unable to meet the necessary liability driven investments (LDI) collateral calls when gilt yields spiked in 2022. These schemes will need to reset their funding and investment strategies and should review their operational governance processes to ensure future resilience. TPRs LDI guidance can be found here.
Covenant Considerations
Employer covenants may appear proportionately stronger given the potential reduction in scheme sizes and the potentially improved funding positions reducing the reliance on the Sponsor. Contingent assets such as guarantees, escrow accounts, and asset-backed funding arrangements expressed in nominal amounts may also now look more favourable.
Despite this Trustees should still place a strong focus on employer covenant and understand the key factors affecting the employer’s resilience. Schemes still remain intrinsically linked their employers until the end game is reached. With the potentially volatile economic conditions moving forward schemes positions may quickly deteriorate and/or the employer may become weaker. It is also important to not overlook the short-term impact of the current economic environment on the employer covenant.
If your sponsoring employer is experiencing corporate distress or acute, near-term affordability restrictions, TPR refers you to their guidance on protecting schemes from sponsoring employer distress.
Actuarial and Investment Considerations
Longevity
Over the last few years, primarily due to the impact from the COVID-19 pandemic, mortality data has not followed past trends. There are differing views on what this may signal for appropriate longer-term mortality assumptions.
Mortality in 2022 onwards may be more indicative of future mortality than previous years, and if so, this cautiously might suggest lower future life expectancies.
TPR expect many trustees will be revising their mortality assumptions after taking advice from their scheme actuary. When doing so, as usual, they should ensure changes to their mortality assumptions are appropriate and justifiable.
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.
Revising recovery plans as a result of an improved funding position
If you are considering whether to reduce or stop Deficit Reduction Contributions (“DRCs”) as part of an actuarial valuation or outside of a valuation, TPR expect the following to be considered:
- The level of prudence in your TPs remains appropriate and the level of investment risk is supported by your current assessment of the covenant.
- Consider reducing the remaining length of the recovery plan before reducing the level of DRCs.
- If allowing for asset returns in excess of the TPs assumptions, you should first consider reducing the additional risk from this before reducing DRCs.
- If shareholder distributions exceed DRCs or covenant leakage is material, it is unlikely to be appropriate to reduce DRCs while in a TPs deficit.
- If outside of a valuation TPR strongly encourages a mechanism is put in place that ensures contributions recommence if the funding position weakens.
The 2023 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