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Steady as she goes: the Pensions Regulator’s 2021 annual funding statement

  • United Kingdom
  • Pensions



The Pensions Regulator recently published its annual funding statement for 2021 (the Statement). The main themes are familiar but there are some interesting insights into the Regulator’s thinking on the fallout from the pandemic and Brexit.  The Statement also highlights some issues you may not yet have focused on, such as RPI changes, the end of LIBOR, the forthcoming “own risk assessment” and new corporate tax reliefs.

The Statement is recommended reading for trustees and sponsors of defined benefit schemes, particularly those with valuation effective dates between 22 September 2020 and 21 September 2021 (Tranche 16 schemes) and any schemes undergoing changes that necessitate a review of their funding or risk strategy.

The Statement is wide-ranging and longer than statements issued in previous years.  This speedbrief summarises key points from the Statement and sets out suggested action points.

What does the Statement say about funding and investment?

Funding levels – The Regulator’s analysis indicates that funding levels for Tranche 16 schemes at 31 December 2020 are broadly unchanged, and at 31 March 2021 are slightly improved, compared with three years ago, with schemes that hedged interest rate and inflation risks doing slightly better. The position for individual schemes will of course vary greatly.

  • Action: Trustees who have strayed from expected funding levels should develop strategies to put them back on course. Schemes that are better funded than expected should remain focused on their long term target.

New funding code – The Regulator expects to publish its second consultation on the new draft funding code of practice towards the end of 2021 (once the DWP has completed its consultation on the draft funding regulations under the Pension Schemes Act 2021), with the new code not coming into force “until late 2022 at the earliest”.

  • Action: Note that the current regime and DB funding code apply until the new law and code come into force. However, as in previous years there are some areas, such as the long term funding target (which trustees are encouraged to set as part of establishing their integrated risk management (IRM) framework), where the Regulator expects elements of the forthcoming regime to be taken into account.

Inflation and RPI – The UK Statistics Authority plans to align the calculation methodology of RPI with CPIH from 2030. CPIH is typically lower than RPI.

  • Action: Where benefit increases or revaluation are linked to RPI, consider assumptions carefully (both before and after 2030). Discuss with advisers whether this change also affects the scheme’s overall funding position and liability hedging strategy.

Mortality in light of Covid – There are different views about the effect of the pandemic on future mortality for DB schemes (though the immediate effect on liabilities currently appears to be low for most schemes). Similarly, views differ as regards the effect on future longevity improvements. The long term effect of the pandemic on liabilities will take time to become clear.

  • Action: Ensure mortality assumptions are balanced (there are suggestions in the Statement as to how this might be achieved, including by attaching less weight to 2020 data). Contingency planning and monitoring are encouraged in case assumptions about higher mortality are not borne out in practice.

Post-valuation experience – As in previous years, the Regulator says post-valuation date experience can be taken into account but this must be done in a balanced way, incorporating both negative and positive events. Where positive post-valuation events are factored in, this should usually reduce the length of the recovery plan rather than reducing annual payments.

  • Action: Post-valuation date experience may be taken into account but this should not simply be used as an opportunity to pick the most favourable date for agreeing the recovery plan.

Maturity – With most DB schemes now closed to new entrants, scheme maturity issues become more significant in setting investment and funding strategies. Benefits paid out also increase as a proportion of scheme assets as the number of pensioners rises, potentially creating liquidity problems and affecting a scheme’s ability to close any funding deficit.

  • Action: Ask advisers to highlight risks arising from increasing scheme maturity. Actively monitor and mitigate liquidity risk in a way proportionate to the scheme profile.

LIBOR/EURIBOR – Both the London Interbank Offered Rate (LIBOR), an interest rate benchmark used in financial markets, and its European equivalent (EURIBOR) are being phased out by the end of 2021. For background information, see our LIBOR Q&A.

  • Action: Check that there is no linkage to LIBOR or EURIBOR in any swaps-based discount rate and that investment consultants and managers are managing the move away from these benchmarks appropriately.

What does the Statement say about employer covenant and risk management?

Covid – The Regulator divides post-Covid employer positions into three broad categories: (1) Covid has had limited impact; (2) the initial impact was material but trading is recovering strongly; and (3) the impact continues to be material. It also considers that all employers should by now have prepared detailed financial projections and updated business plans, and provided those to trustees promptly.

  • Actions: Trustees should decide in which of the Regulator’s three categories the employer belongs. Carry out stress testing or scenario planning reflecting possible future economic environments – this is particularly important for employers in category (3). Do not assume a full recovery in covenant support without good justification.

Brexit – Depending on the nature of the employer’s business, uncertainty over employer covenant may be heightened by changes in trading conditions due to Brexit.

  • Action: Review and understand whether any impact of Brexit on covenant is short term or a more fundamental challenge.

DRCs and Covid – As in previous Covid-related guidance, the Regulator warns that deficit reduction contributions (DRCs) should not be reduced except where suitable mitigations are obtained, for example contingent assets, shareholder distributions ceasing and additional contributions linked to measurables like free cash flow or the triggers in management bonus incentive programmes.

  • Action: Do not agree to DRC suspensions or reductions without suitable mitigations. Be vigilant for covenant leakage and seek suitable protections.

DRCs and tax changes – Corporation tax is due to increase to 25% in 2023 and new capital allowances, including a special 130% “super-deduction”, designed to boost business investment, apply until 31 March 2023. Some employers may request short term DRC deferrals to take advantage of this. 

  • Action: If the employer requests DRC deferrals to take advantage of short term tax allowances, bear in mind the Regulator’s Covid guidance and seek appropriate mitigations (such as contingent assets) for the deferral period.

Covenant visibility and monitoring – The Regulator encourages trustees to obtain independent specialist advice to support covenant assessment, particularly where the covenant is complex or deteriorating, and says best practice is to identify key aspects to track and decide when action is required. It notes with approval that most trustees have increased the frequency and intensity of covenant monitoring. 

  • Actions: Consider getting specialist covenant advice if you do not already do so. Continue the frequency and intensity of covenant monitoring until economic uncertainty subsides and put in place contingency plans for when adverse changes are detected. Discuss key risks with the employer so that both parties are ready to respond if a trigger is breached (ideally with specified actions for agreed trigger points).

Corporate transactions – Corporate activity levels are likely to increase as we emerge from the pandemic. This will include not only distressed employers selling assets and restructuring but also companies encouraged by low interest rates to take on new debt to fund acquisitions.

  • Actions: Trustees should familiarise themselves with the new procedures for distressed employers under the Corporate Insolvency and Governance Act 2020 (see further our speedbrief). Be ready to act and ensure you “get a seat at the table” early in the event of a corporate transaction for which mitigation needs to be negotiated. The transaction-related notification framework in the Pension Schemes Act 2021 should help with this but it may not be in force for some time.

Climate change – As before, the Regulator expects trustees to focus on the IRM of investment, covenant and funding risks and to have in place an IRM framework and governance processes. Part of this is to consider the risks posed by climate change on investment strategy, sponsor covenant and valuation assumptions.

  • Action: Consider the risks posed by climate change on all three elements of IRM.

Long term funding targets – As in previous years, the Regulator reminds us that the Pension Schemes Act 2021 will, once the funding provisions are in force, require DB schemes to set out a specific end-goal, the long term funding target (LTFT), and to put in place plans for how to get there. It encourages trustees to incorporate this approach into their thinking and agree it with their employer.

  • Action: Trustees and employers who have not done so already should discuss their scheme’s LTFT and agree a strategy for achieving it and managing any short term deviations from the plan.

IRM and the new ORA – The Regulator’s draft single code of practice (for more information, see our speedbrief) proposes that occupational schemes with 100 members or more will need to carry out and document an annual “own risk assessment” (ORA) which provides a process for assessing the management of risk.

  • Action: Documenting key risks and how they are managed within an IRM framework at the current valuation should make the scheme’s first ORA (a significant task) easier.

Risk tables – As in previous years, the Statement includes detailed tables setting out the Regulator’s expectations depending on scheme and employer characteristics. There are no material changes compared to last year’s version.

  • Action: Trustees and employers should work with their advisers to decide which group their scheme fits into, taking into account any changes arising from Covid, Brexit, increased maturity, etc.