Regulator publishes 2023 funding statement

News Alert 2023/04

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

Rethinking strategies: funding position

In this section the Regulator sets out guidance depending on the scheme’s funding position.

• Where funding has reached buyout levels (which the Regulator believes to be the case for around 25% of DB schemes) the guidance is focussed on the scheme’s endgame, pointing out the necessary preparation should buyout be the preferred route. Where the preference is instead to run the scheme on, possibly using the surplus to fund DC contributions or pay expenses, the guidance notes issues to consider including mitigating some of the risks by using part of the surplus to create a specific risk buffer
• Where funding is above technical provisions but below buyout, the guidance is about the need to focus on the long-term objective and a timescale for reaching it, and potentially accelerating that process. There is a further push to agree a long-term funding target as a matter of urgency if this has not already been done.  The guidance also suggests that such schemes consider the steps they can take now to align (even broadly) with the key principles of the draft funding code
• Where schemes still have a technical provisions deficit, the focus should be on repairing that deficit as soon as the employer can reasonably afford, checking that the technical provisions are aligned with the long-term funding target, and that risk being taken is supported by the employer covenant

Rethinking strategies: investment considerations

Here the Regulator highlights the rise in long-term global interest rates in 2022 with the resulting poor performance of bonds, particularly in the UK.  There is a warning that asset allocation may be very different to where it was expected to be and the Regulator flags the need to review investment strategy in the light of a changed funding position.  The likely opportunity to de-risk, for at least closed and mature schemes, is mentioned.  Separately, the operational challenge faced by LDI positions is covered with a pointer to the Regulator’s April 2023-issued trustee guidance (see News Alert 2023/03).  The potential challenge if illiquid assets are a greater proportion of scheme assets than originally envisaged is also mentioned with some factors set out for consideration.

Rethinking strategies: covenant considerations

This section is essentially a reminder that until the scheme has reached its end-game, covenant remains important, especially where risk is being taken with the investment strategy.  As a result, trustees need to avoid complacency despite significantly improved funding positions for many schemes.

Warnings are sounded in relation to corporate borrowing costs, higher energy costs, potential reduction in demand and the effect of higher short-term inflation on input costs and operational expenses.  All of these could constrain the affordability of deficit repair contributions and the ability of the employer to support the scheme’s investment risk taking.

There is also a suggestion that for well-funded schemes where no recovery plan is needed, covenant assessment could focus more on its longevity, including the potential impact of ESG risks, and be less focussed on uses of free cashflow.

Other considerations

Finally, there is some guidance in the following four areas:

• Longevity – where the Regulator is now of the view (along with other commentators) that mortality rates from 2022 onwards may be more indicative of future mortality than previous Covid-influenced years, and if so, this may suggest lower future life expectancies than those set pre-pandemic. Trustees are cautioned to proceed with care if they wish to weaken existing assumptions, but interestingly there is no mention of a 2% liability reduction backstop as there was last year
• Inflation – the Regulator’s views on the challenges presented by high inflation, set out in the 2022 statement, are reprised
• Revising recovery plans and contingent assets – there is some useful guidance for where a reduction or cessation of deficit repair contributions is being considered as part of an actuarial valuation, or has been requested outside the valuation cycle, both in the context of the scheme having a funding position that is ahead of where it intended to be. And separately, where the employer wants to renegotiate the terms of a contingent asset agreement in the light of improved funding
• Assessing refinancing risk – the topical issue of refinancing against the backdrop of interest rate increases and tightened risk appetites of lenders is covered. The Regulator asks that refinancing risk be incorporated into covenant analysis and information sharing agreements and monitoring.  Where such refinancing is expected to be well progressed prior to the completion of the valuation, the covenant analysis should not be finalised until the terms of the refinancing become clear.  Where refinancing will fall after the valuation date but still within the short term, trustees will need to consider how it could affect future covenant support

What to expect from the Regulator

The Regulator starts by mentioning the draft funding code, saying that it now expects it and the accompanying funding and investment regulations to come into force together in April 2024 (for valuation effective dates from, it seems, that date) and that until then the existing code and guidance remain in place.  There is also a promise to publish updated covenant guidance (and other related guidance) later in 2023.  This is to provide more detail on covenant visibility, reliability and longevity, how to treat guarantees for scheme funding purposes and more information regarding ESG risks and how these can be factored into the covenant.

As before, there is the usual 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.  There is also the same promise that each valuation submission the Regulator 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 concludes with a reminder of its powers under the current scheme funding law and that it may carry out investigations where it believes trustees and/or employers have not acted in line with its expectations set out in this annual funding statement, and in relevant policy statements, guidance and codes of practice.

Key risks and the Regulator’s expectations

At the end of the statement the Regulator once more 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, with each further sub-divided according to whether the scheme is relatively immature or relatively mature:

The above funding descriptors differ slightly from those in 2022, with the exception that those for B and D scheme types has been changed from “Funding level strong” and “Funding level on track to meet LTFT” respectively in the 2022 statement to “Funding level behind plan”.

The Regulator’s assessment of the key risks facing each category has been reiterated in the tables with little change from that in earlier years, except that the shorter timeframe for aligning with the long-term funding target is now highlighted for the B and D type mature schemes.

The actions expected in 2022 under each of covenant, investment and funding have been carried forward to this year’s statement to which are added the following sprinkling of new expectations:

• Scheme types A, B and C are asked to review their LDI strategy and assess it for operational resilience – the Regulator’s recent guidance being highlighted (see News Alert 2023/03)
• Immature A and B scheme types are expected to understand longer term risks including ESG factors
• Mature A scheme types that are close to surplus are expected to test the adequacy of their technical provisions against the assets needed to satisfy their long-term funding target
• Immature D scheme types must focus on strengthening technical provisions, increasing deficit reduction contributions and reducing recovery plan lengths

Trustees are asked to find the scheme type closest to their circumstances, which should help them determine the direction and magnitude of change to their funding and investment strategies, the risks they need to focus on, and the actions expected.  They should then prepare their recovery plans to balance affordability with other reasonable uses of cashflow for the employer.