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Navigating choppy waters: the Pensions Regulator’s annual funding statement

  • United Kingdom
  • Pensions

17-05-2022

The Pensions Regulator recently published its annual funding statement for 2022 (the Statement). The main themes are familiar but some of the emphasis has changed and there are insights into the Regulator’s thinking on addressing current challenges including rising inflation, higher interest rates, the situation in the Ukraine and the impact of the pandemic on mortality. 

The Statement is recommended reading for trustees and sponsors of defined benefit schemes, particularly those with valuation dates between 22 September 2021 and 21 September 2022 and any schemes undergoing changes that necessitate a review of their funding or risk strategy.

This speedbrief summarises key points from the Statement and sets out some suggested action points.

What does the Statement say about employer covenant?

Covenant monitoring – Recognising that recent events have led to differing experiences for businesses depending on the market in which they operate, the Regulator divides employer positions into three broad categories: (1) current market events had limited impact; (2) the initial impact was material but trading has recovered/is recovering strongly; and (3) the impact continues to be material. Trustees should gauge how current market events are affecting the employer and decide in which of the Regulator’s three categories the employer belongs.

Forecasting – Given recent trading volatility, the Regulator considers it more important than ever for trustees to engage with management. Trustees should carry out scenario planning and should seek to monitor actual versus forecast performance, so that they can respond quickly and appropriately if covenant deteriorates.

Recovery plans – The ability of the employer to afford deficit recovery contributions (DRCs) will depend on the impact of current market conditions on its business. Trustees should assess this based on the relevant covenant category.  Where market conditions have had limited impact, the Regulator cautions against reducing DRCs or extending recovery plan end dates. For employers with short term affordability problems, any reduction in DRCs should be short term, with higher contributions in future years to avoid extending recovery plan end dates. The Regulator sees paying distributions to shareholders as inconsistent with lower DRCs.  The Regulator specifically states that Trustees with asset-backed contribution arrangements should consider the impact of current market conditions on the value of this support.  

Distributions to shareholders – With the Regulator seeing a recent increase in dividends and other forms of “covenant leakage”, the emphasis (as per the 2019 annual statement) is on treating the scheme fairly as compared to shareholders. Where distributions exceed DRCs, a strong funding target and a short recovery plan are expected. The Regulator also expects trustees to be vigilant in identifying non-dividend forms of covenant leakage such as management fees, cash pooling and group trading arrangements. It notes that dividend sharing mechanisms or negative pledges could potentially be built into valuation discussions.

What does the Statement say about actuarial and investment issues?

Interest rates – The funding impact of rising interest rates will depend on scheme investment, funding and hedging strategies.

Inflation – The effect of rising inflation will be scheme-specific. Trustees should discuss any salary increase assumptions with employers to ensure they remain appropriate and realistic in light of current market conditions. Trustees should also seek to understand how any inflation hedging they have in place works, particularly as current inflation may well be exceeding caps on benefit increases.

Inflation is also expected to rise in the long term, which could increase liabilities. Trustees are encouraged to consider how inflation changes will affect any long term funding strategy. In addition, the UK Statistics Authority plans to align the calculation methodology of RPI with CPIH (which includes housing costs) from 2030. CPIH is typically lower than RPI. The High Court is due to hear a judicial review challenge on this during the summer. The Regulator suggests that trustees choose their pre- and post-2030 inflation assumptions based on the current understanding of the position.

Mortality – There are different views about the effect of Covid on future mortality for DB schemes and the long term effect will take time to become clear. Interestingly, however, the Regulator gives a specific steer as to what it considers appropriate and justifiable in this context – it expects any reduction in liabilities “to be no more than 2%, unless accompanied by strong supporting evidence”.

What does the Statement say about managing risk?

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, and to put in place plans for how to get there. It encourages trustees to incorporate this approach into their thinking, taking into account in particular the covenant risks that could affect the journey, and agree it with their employer.

Monitoring and contingency planning – The Regulator again emphasises the need to identify and monitor key covenant and other risks and to have contingency plans in place setting out specific actions where metrics are breached. In a new addition this year, trustees of schemes in surplus on the technical provisions basis are encouraged to remain focused on managing risks through contingency planning (including contributions linked to funding and risk triggers), which should help to alleviate concerns from employers about trapped surplus.

Risk tables and expectations – 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 except that the reference to the length of the recovery plan has changed from seven to six years, to reflect the current average length. Trustees should work with their advisers to decide the group into which their scheme fits.

What about the new funding rules under the Pension Schemes Act 2021?

The current funding regime applies until the new funding law (under the Pension Schemes Act 2021 and forthcoming regulations) and the revised DB funding code of practice come into force. The Regulator has said that draft DWP funding regulations and a new draft code are expected this year.