The Pensions Regulator has issued its annual funding statement, setting out its expectations of valuations with effective dates between 22 September 2014 and 21 September 2015.
Managing risk
The Regulator expects trustees to understand their scheme’s sensitivity to different risks, including the likelihood of those risks occurring and the resultant impact on the scheme, and then set and manage investment and funding strategies that carry an appropriate level of risk.
It encourages trustees, in discussion with employers, to undertake contingency planning to enable prompt action, where necessary, should certain risks materialise.
Market conditions and investment returns
The Regulator expects that many schemes with 2015 valuations will have larger funding deficits than in their 21012 valuations, because of the impact of falling Gilt yields and schemes not having fully hedged their exposure to this risk.
The statement notes that expected investment returns are usually used to derive the discount rates used to calculate technical provisions and/or the assumption for asset returns over any recovery period. However, it points out that trustees should consider the potential impact on their scheme of different scenarios for investment returns and understand what action, if any, could be taken if returns turn out lower than anticipated. The Regulator is expecting that most schemes will assume lower expected investment returns than at their last valuation.
The statement notes that some schemes allowed, in their last valuation, for Gilt yields to revert to a higher level, or to rise sooner, than implied by the markets and that this expectation has not been borne out. There is a warning for trustees who may be considering assuming such reversion in their current valuation, that they should consider the implications for their scheme funding if yields continue to fall or rise more slowly than anticipated.
Recovery plans
The Regulator reminds trustees that longer recovery plans can result in an increase in scheme risks, as confidence in the employer’s covenant and in expected investment returns reduces over time.
The Regulator suggests that schemes which have chosen previously to take a more prudent approach, or whose employer covenant has improved, may have capacity to take additional risk and so be in a better position to manage the risks arising from a larger than expected deficit at the 2015 valuation. It expects that they will be able to address their deficit through a modest extension to their recovery plan, a modest increase in contributions and/or changing their assumptions relating to investment returns.
On the other hand, other schemes may have less capacity to take additional risk and have limited options for addressing a higher deficit. Where the sponsoring employer can pay more contributions without adversely affecting its sustainable growth plans, the Regulator expects trustees to seek higher contributions with a view to maintaining the end date of the recovery plan.
Where the employer’s affordability is constrained (for example through reduced profitability or plans to service debt or increase necessary capital expenditure) trustees may be faced with lower contributions than they think the scheme needs. In such cases, trustees should undertake a higher level of due diligence on the employer’s affordability. In such circumstances trustees should seek additional security for the scheme. Where trustees have to accept a greater level of risk, it emphasises the need for them to have a robust monitoring framework in place to identify any further increase in the scheme’s risk profile.
If investment in an employer’s business is being prioritised at the expense of deficit contributions, it is important that this investment is being used to improve the employer’s covenant.
Defined contribution (DC) flexibility
The Regulator notes the potential effect on defined benefit schemes of the new DC flexibilities, which may lead to more transfers out of DB schemes. Trustees should seek advice on the likely effect of such an increase on the funding of their scheme.