This month saw the Pensions Regulator (tPR) release its annual funding statement, in which it sets out its guidance for, and expectations of, pension scheme trustees and sponsors. Many of our clients will recognise tPR’s emphasis this year as consistent with the topics that we have been discussing for a while, and welcome the greater clarity on what is considered ‘best practice’ for schemes.

In this note we summarise the key takeaways of the statement, our views, and some questions we think trustees should be considering for themselves and their advisers.

Long Term Funding Target

Many schemes that we work with have either reached full funding on a technical provisions basis, or are at a point where it is within touching distance. Ten years ago, in the midst of the Financial Crisis, this would have been a moment to celebrate, considering the difficult position many found themselves in. What tPR are asking of trustees and sponsors is not to view this as “job done”, but rather as a stepping stone on a longer path.

For the vast majority of schemes this means over time moving towards a de-risked position with reduced reliance on the sponsor. What a desirable de-risked position represents will mean different things to different schemes, and the landscape of the pensions industry is fast evolving.

The “gold standard” remains buying the scheme out with an insurer, although now we are seeing the emergence of consolidators who potentially offer an alternative and more affordable means of risk transfer. Another option is for schemes to reach a “self-sufficient” position, where a scheme runs as a going-concern, with less assets than would be needed for buyout, but where there is limited reliance on the sponsor and a low level of funding and investment risk.

For schemes, there are also some key questions which are often overlooked, or more challenging to assess in developing a long-term plan.

What are the long term risks to your sponsor covenant?

In-depth reviews, undertaken by many schemes at each triennial actuarial valuation, are generally good at giving a solid understanding of the covenant strength today and over the short to medium term. However they put far less emphasis on longer term forecasts. Although no one has a crystal ball, it is important to think about how the covenant could evolve over the next 10-20 years. This means applying a wider lens: what risks are there to disruption or obsolescence in the industry; are these from possible societal or technological changes, or perhaps climate change related? For example, for a car insurance company what is the risk to their business model from the advent of driverless cars?

These questions are often environmental, social and governance related – proving that understanding of ESG factors are just as important in the covenant piece of the funding puzzle as the investment strategy piece.

What does "self-sufficiency mean in practice?

If a scheme is running in self-sufficiency then this must mean the scheme has less assets than needed for buyout (otherwise why wouldn’t you buy-out?).

The big question for a scheme in that position is what happens if the sponsor goes bankrupt? Will the scheme buy-out benefits below the level promised to their members or run on without a sponsor?

As noted, self-sufficiency is commonly defined as a position where there is minimal reliance on the sponsor covenant and minimal investment risk. But “minimal” is not the same as nil. For that reason, our view is that in any long term planning it is important for trustees to understand:

• How big the gap is between any self-sufficiency target and buy-out, and how this is expected to evolve with time.
• How much prudence is contained in the Self Sufficiency liability assumptions, this has focused on discount rate historically but should also include areas such as longevity and RPI/CPI risk.

A focus on maturity

“Cashflow negativity” is a topic increasingly on many schemes’ agendas as deficit repair contributions cease and/or they close to new accrual. “Cashflow negativity” in and of itself is not necessarily a bad thing for a scheme. As tPR make clear in their statement, what matters is the confluence of this with funding level and asset volatility.

We fully agree that maturity needs to be a consideration for many schemes however as with any risks you need to understand the size of the risk and how to mitigate it, for example:

• We have built analysis that allows us to understand given the confluence of benefit payments, funding level and investment risk what is the size of your maturity risk today.
• This can also be run through time to help a scheme understand when in the future this may become a significant risk (if ever).
• The key here is that if you are running a low risk investment strategy and are well funded then actually maturity risk is pretty minimal.
• As a result we think schemes should look to achieve a strong level of funding as quickly as possible so that maturity risk never becomes a risk – this is the easiest way to manage it.

Treating shareholders and schemes equitably

This has been a key area of focus for tPR and was discussed in their 2018 annual statement however this year they have gone further in being explicit with what they see as reasonable in terms of deficit repair contributions (DRCs) and payments to shareholders:

• Where the payments to shareholders are larger than DRCs then they expect this to imply strong funding targets and short recovery plans.
• For employers who are tending to weak or weak then DRCs should be larger than shareholder payments unless the Recovery Plan is short or funding position strong.
• Where the employer is weak and unable to support the scheme then they expect there to be no payments to shareholders.
• As a result we think schemes should look to achieve a strong level of funding as quickly as possible so that maturity risk never becomes a risk – this is the easiest way to manage it.

This should be welcomed by trustees in negotiation with a sponsor, where they have very concrete guidance to point to which could lead to a stronger bargaining position.

Recovery Plans

tPR noted that the average recovery plan was seven years, and they expect if a scheme has a strong sponsor covenant then the recovery plan should be shorter than this. As part of this they have the intention to engage with some schemes as they move through their valuation process in 2019.

Once again this is another part of the statement which many trustees will find useful in negotiating Recovery Plans with the Sponsor.

Questions for trustees to consider

In our view, the 2019 statement raises a number of questions for trustees to ask themselves and their advisors.

• How does your Recovery Plan and deficit repair contributions compare to tPRs expectations?
• Have you considered what a long-term funding target for your scheme is and what the journey there looks like?
• To what extent have you assessed and incorporated wider and longer-term industry, technological, societal and environmental risks to the sponsor covenant into your thinking?
• If your target is self-sufficiency, do you have a grasp of the magnitude of the residual investment and liability risks which you would still be running once you get there?
• Would your strategy benefit from measures which would better manage your current and future liquidity needs (for example cashflow matching assets)?