Greater Expectations – the Pension Regulator’s annual funding statement

• United Kingdom

• Education - Briefings

22-03-2019

In what has become an early spring tradition, the Pensions Regulator recently published its annual funding statement for 2019 (the Statement). The general themes are familiar but the statement is more detailed than in previous years and contains interesting insights into the Pensions Regulator’s thinking.

The Statement is recommended reading for trustees and institutions who sponsor a defined benefit scheme (other than a public sector scheme such as the Local Government Pension Scheme or Teachers' Pension Scheme), particularly those with valuation effective dates between 22 September 2018 and 21 September 2019 and any schemes undergoing changes that necessitate a review of their funding strategy.

Long term funding target

The Government plans to require all defined benefit schemes to set out a specific “long term financial destination” (i.e. an end-goal), which it calls a long term funding target (LTFT). This could, for example, be buy-out, self-sufficiency or transferring to a consolidator vehicle.

While this new requirement may not yet be in force, the Regulator expects schemes “to set a LTFT consistent with how the trustees and employers expect to deliver the scheme’s ultimate objective, and then be prepared to evidence that their shorter-term investment and funding strategies are aligned with it”. This goes well beyond becoming fully funded on a technical provisions basis.

Balancing risks

The Regulator continues to focus on the integrated management of the three broad areas of risk: covenant, investment and funding.

It lists some of the factors it uses to assess the overall risk profile of each scheme and puts a new emphasis on taking account of risks that arise from scheme maturity. This reflects the fact that most defined benefit schemes are now closed to new entrants. The Regulator says that, as benefits paid out increase as a proportion of scheme assets or liabilities, this can “put a different complexion” on the risks to be managed, especially investment volatility.

Whilst not referred to in the statement, for education-sector institutions, the Regulator will likely be also looking to the implications of funding pressures in the sector (e.g. increases in Teachers’ Pension Scheme contributions, post-Brexit student income etc.).

Risks and expectations

The Statement includes detailed tables setting out the Regulator’s expectations depending on scheme and employer characteristics. These are divided into ten separate sections ranging from A1 (immature scheme, strong or tending to strong covenant) to E2 (mature scheme, weak employer unable to provide support), with different expectations set out for each.

Trustees and institutions should work with their advisers to decide which section their scheme fits into. The expectations are more detailed than in previous years and will require careful consideration.

The Regulator is adopting its increasingly common “comply or explain” approach here – while recognising that “individual scheme circumstances might mean alternative action is appropriate”, it expects trustees to be able to justify deviations from its stated expectations.

The Regulator says that it expects scheme actuaries to advise trustees on the position of their scheme in the maturity spectrum now, and how it may change in the future. It also expects advisers to alert schemes with a high level of transfer activity to the risks of this to funding and investment.

Equitable treatment: dividend payments and other “covenant leakage”

Against the background of recent high profile corporate failures, the Regulator remains concerned about schemes being treated fairly compared to other stakeholders, in particular the disparity between dividend growth and stable deficit repair contributions (DRCs).

While dividends are not directly relevant to the majority of educational institutions, by analogy the Regulator will likely be concerned that institutions’ defined benefit schemes are getting the DRCs in proportion to other expenditure (e.g. capital projects).

The Regulator has set out its expectations as follows:

• where dividends and other shareholder distributions exceed DRCs, the Regulator expects a strong funding target with relatively short recovery plans;

• if the employer is tending to weak or weak, it expects DRCs to be larger than shareholder distributions unless the recovery plan is short and the funding target is strong; and

• if the employer is weak and unable to support the scheme, it expects the payment of shareholder distributions to have ceased.

As noted above, these expectations set out in the Statement do not readily apply to education institutions. However, for example, it would be reasonable to assume that where an institution has a weak or tending to weak covenant, the Regulator is likely to expect that DRCs should be prioritised over other non-essential areas of expenditure.

The Regulator is also concerned about other forms of “covenant leakage” which may be occurring in preference to paying higher DRCs and shorter recovery plans. It plans to focus interventions on equitable treatment and covenant leakage in 2019 and to cover a larger number and greater range of schemes, regardless of covenant.

Long recovery plans and other interventions

The Regulator plans to engage with a number of schemes ahead of their 2019 valuation where it considers existing recovery plans to be “unacceptably long”. Trustees and employers with “significantly long” recovery plans at their last valuation may receive a communication from the Regulator “in the coming months”. Schemes selected for engagement will cover the whole spectrum of covenant strengths. Scheme maturity will also be a key factor here.

The Statement notes that the median recovery plan length is seven years. It says that schemes with strong covenants should generally have recovery plans that are “significantly shorter than this”.

The Regulator plans to engage with schemes where it has concerns about certain other characteristics of the funding and investment plans, in the context of the covenant and scheme profile. Trustees and employers are warned (in another example of the “comply or explain” approach) that they must be prepared to justify their approach with evidence of robust negotiations having taken place.

This is of particular interest to institutions with DB schemes, as historically many recovery plans in the education sector were longer owing to the fact that long-term funding was consistent and institutions’ perceived insolvency risk was low. However, the Regulator may look to put more pressure on institutions to decrease the length of their recovery plans in light of the financial headwinds in the sector.

Late valuations

In recent years, the Regulator has started coming down harder on late valuations. It reiterates the message that trustees should start the valuation process in good time and that it may impose a penalty if the submission deadline is missed.

It also notes that trustees should not agree an inappropriate valuation and funding plan merely because the deadline is imminent or has been missed - if pushed to do so by an employer, they should contact the Regulator. If the deadline is looming or missed, parties should also report to the Regulator promptly. The Regulator says its preference is the best outcome for the scheme rather than one agreed under pressure simply to meet a deadline.

Regulator powers

In its final remarks, the Regulator notes its existing powers and the investigations currently underway where it may exercise its scheme funding powers. With additional powers on the cards following the Government’s recent response to the “Stronger Pensions Regulator” consultation, the Regulator will be even better armed to deal with trustees and employers that do not heed its warnings.

Action points

The following suggested action points arise from the annual statement.

• Establish which of the Regulator’s 10 risk categories you think your scheme falls into. Consider the Regulator’s expectations for that category and be prepared to justify deviations.

• Ask your actuary to advise on the position of the scheme in the maturity spectrum and how this may change in future.

• Ask your advisers to monitor your transfer levels and, if transfer levels are high, to report on how this affects funding and investment.

• If you have a long recovery plan or other non-standard funding or investment characteristics, be prepared for possible Regulator engagement.

• Decide on an end-goal and set a LTFT consistent with that.

• Consider whether your institution could be criticised in the priority of its DRCs or anything that can be perceived as “covenant leakage” in light of the Regulator’s stated expectations – is the scheme being treated fairly?

• If running up against a valuation submission deadline, engage with the Regulator and do not feel pressured to agree simply to meet the deadline.

• As always, evidence robust negotiations between trustees and employer and be prepared to justify your approach.

• Watch out for the Regulator’s new defined benefit funding code, which is due to be consulted on in summer 2019. We can expect it to up the game even further.