Regulator publishes 2022 funding statement

News Alert 2022/03

At a glance

The Pensions Regulator has issued this year’s DB funding statement.  As in previous years it sets out the Regulator’s key messages for trustees and sponsors of schemes who are undertaking valuations at the current time or are undergoing significant changes that require a review of their funding and risk strategies.

Key actions for trustees and scheme sponsors

• If not already done so, assess the impact that current market challenges are having on covenant and consider the implications for funding and investment
• Establish which group described in the tables the scheme most closely resembles and assess whether the statement affects the current approach being taken in relation to covenant, investment and funding issues
• If not already done so, set a long-term funding target (LTFT) and establish a journey plan for progressing to the LTFT, ensuring that investment and funding strategies in the interim period are aligned
• Consider carefully whether and how to allow for the long-term impacts of Covid-19 in mortality assumptions, in light of the Regulator’s guidance

The Detail

On 27 April 2022 the Pensions Regulator issued its annual funding statement, aimed at trustees and sponsors of DB schemes.  The statement is focussed on schemes with valuations with effective dates between 22 September 2021 and 21 September 2022 as well as schemes undergoing significant changes that require a review of their funding and risk strategies.

The statement also highlights the Regulator’s views on general risk management practices, regulatory developments and current issues facing schemes, which are expected to have a bearing on pension scheme management.  Many of the messages are similar to those in last year’s statement and where this is the case reference is made back to that statement.

Once more, although the statement is inevitably influenced by how the new funding regime is intended to operate, the Regulator confirms that all valuations subject to this statement will be regulated “according to the requirements of the existing legislation and guidance currently in force”.

Considerations for schemes currently undertaking a valuation

The Regulator introduces the substance of this year’s statement by acknowledging the significant economic uncertainty in which valuations are currently being undertaken, which could have an impact on employer covenant and scheme investments.  High rates of inflation, higher global energy and fuel prices and the potential for further increases in interest rates are mentioned.  Three significant events are also called out – the conflict in Ukraine, Covid-19-related disruption and the impact of Brexit.

Much of the Regulator’s commentary is focussed on the potential downsides to covenant so it is no surprise that it then turns to some considerations under this heading.

Covenant considerations

The Regulator points to the importance of assessing how current market events are shaping the employer covenant, suggesting that trustees continue to categorise in a similar manner to its suggestion in last year’s statement.

It then turns to four separate aspects:

• Forecasts and scenario planning – given recent trading volatility, trustees should engage more with the employer to understand key variables and factors driving financial projections and business plans and use stress testing or scenario planning to understand the covenant impact of future economic environments
• Recovery plans and affordability – the approach that trustees take to setting recovery plans and paying deficit repair contributions should be driven by the impact that current market conditions have had on the employer’s business and on any reliance they are placing on any contingent support
• Shareholder distributions and other forms of covenant leakage – noting a return to employers returning cash to shareholders, it is expected that the scheme should be treated at least fairly compared to other stakeholders. Also, that trustees should remain vigilant of other forms of covenant leakage – including cash pooling arrangements, group trading arrangements and management fees
• Corporate transactions (which remain high) – trustees should continue to take a rigorous approach to assessing the impact of any transaction and record the considerations made in respect of the scheme. Mitigation for any detriment caused should be sought prior to separately considering the valuation

Actuarial and investment considerations

Three topics appear under this heading:

• Interest rates – the recent rise in long term interest rates and gilt yield volatility is highlighted, with the Regulator acknowledging that the funding impact will depend on scheme investment and funding strategies and the level of hedging in place
• Inflation – the challenge presented by recent and short-term inflation as far as valuation calculations are concerned is mentioned (including in relation to caps and collars that apply to benefits), as is the need to understand how any inflation hedging is working in the current environment. When it comes to long-term inflation expectations the same caution is expressed as last year when setting pre- and post-2030 inflation assumptions.  New for this year is that higher long-term inflation expectations are likely to have increased many schemes’ liabilities.  The Regulator also asks trustees to consider how current and potential future interest rates and inflation changes will impact on any long-term funding strategy
• Mortality – once more the Regulator covers the impact from the pandemic on scheme mortality, but there has been a subtle change of emphasis. Whereas last year it said that it expected trustees to justify any material weakening of their mortality assumption on account of the pandemic, now it says that where trustees feel that changes to their mortality assumptions at this stage are appropriate and justifiable, it expects any reduction in liabilities due to such changes to be no more than 2%, unless accompanied by strong supporting evidence

Managing risks

Three topics appear this year under the above heading:

• Long-term funding targets – as in previous years the Regulator calls on trustees to consider taking steps now, if they have not already done so, to adopt a long-term funding strategy, agree it with the employer and set journey plans accordingly
• Longer term reliance on covenants – as part of the above, trustees are asked to understand particularly the longer term risks that could result in changes in covenant and use this to inform their journey plans
• Monitoring and contingency planning – regular monitoring and the need to have actionable contingency plans is once more emphasised. New this year is some commentary on schemes in surplus (on their funding basis), with trustees being asked to remain focussed on their LTFT and journey towards it, which amongst other things may help to address employer concerns about trapped surplus

Key risks and the Regulator’s expectations

Once more the Regulator provides a comprehensive set of tables in which it sets out its expectations across covenant, investment and funding, which differ according to the characteristics of the scheme.  There are five scheme types as follows:

each of which is further sub-divided according to whether the scheme is relatively immature or relatively mature.

The tables are the same as those in last year’s statement, with references to the recovery plan length adjusted slightly from seven to six years, which the Regulator says reflects a reduction in average recovery plan lengths in recent years.  Trustees are asked to find the table closest to their situation and prepare their recovery plan to balance affordability with contributions linked to well-defined triggers, contingency plans and other protections for member security.

What to expect from the Regulator

As before, this starts with a reminder that trustees are the first line of defence for savers and their pension schemes, promising Regulator engagement with schemes if trustees have concerns over corporate distress.  It also, as before, reminds trustees that each valuation submission it receives is risk-assessed in a proportionate way and that “Trustees and employers should be fully prepared to justify and explain their approach with supporting evidence”.

The Regulator then goes on to state that its second consultation on the draft DB funding code is expected to be launched “later in 2022” and that as part of this it plans to consult on updated guidance for covenant assessments.