In its first annual funding statement, the regulator set out how pension scheme funding valuations should be approached in the current economic climate. The advice is aimed at trustee and employers of defined benefit pension schemes undertaking valuations which are effective between September 2011 and September 2012 – this is about a third of the UK’s DB schemes, with around four million members.
The regulator said there was ‘significant flexibility’ in the funding framework to enable schemes and employers to meet their long-term liabilities including – where necessary – filling deficits over longer periods and taking account of improved market conditions post-valuation.
Employers should, as a starting point, maintain current deficit recovery contributions in real terms, it said. They will also have demonstrate whether any alternative use of cash that could otherwise be used to increase their contributions to a scheme will strengthen their ability to support the scheme – the ‘employer covenant’.
Trustees and employers following this guidance are more likely to reach funding agreements acceptable to the regulator, it said.
Bill Galvin, the regulator’s chief executive, said: ‘Pension schemes are long-term undertakings. A resilient economy and a healthy sponsoring employer provide the best environment for delivering pension promises.
‘The economic climate continues to be challenging, but the majority of schemes and sponsoring employers should be able to meet their promises to members without major adjustments to their current plans. Trustees must produce credible recovery plans in light of all the risks, including employer insolvency.
He added: ‘Employers that are struggling have greater breathing space to fill deficits over a longer period. However, we will draw a distinction between this group and those cases where schemes are substantially underfunded and employers are able to afford higher contributions. In such cases we will expect pension trustees to be taking steps to put their scheme on a more stable footing.’
The regulator acknowledged calls for it to allow schemes to make allowances for low gilt yields and the effects of quantitative easing in the assumptions they use, which would reduce their funding targets.
But this would not be a prudent approach it said, because it aims to ‘second guess’ future market conditions. The regulator noted, however, that it would consider additional flexibility in recovery plans if employers were genuinely struggling to support their scheme.
Mr Galvin added: ‘There are a number of economic factors impacting gilt yields, such as QE and demands for UK sovereign debt from the international banking sector.
‘We have been in a low interest climate for some time. Yields have fallen further in the last nine months, and it is unclear when and to what extent there will be a market correction. The net effect across defined benefit schemes is not uniform and will vary greatly depending upon the extent to which their risk-management, investment and contribution strategies have insulated them from the effects.’
However, the statement was criticised by the CBI which said it had failed to address the impact that QE has on pensions.
Neil Carberry, director of employment and skills policy for the business group, said: ‘Although QE has been necessary to support the economy, one side effect has been to make pension scheme deficits look artificially big by lowering gilt yields at the very moment when firms are also doing their three-yearly valuation.
‘While the Pensions Regulator acknowledges this side effect of QE in its first annual statement, its advice to trustees fails to deal with the problem - how “technical provisions”, the amount required to cover a scheme’s liabilities, are calculated. We need to take more account of the effects of QE when making the calculation.’
He added: ‘To help the private sector provide both the growth we need and the pensions firms have promised to employees, the current method of valuing a pension fund must change. It cannot be right that pension schemes with very long-term liabilities, which make them less vulnerable to short-term market fluctuations, have to fund against spot valuations. Greater smoothing is required using data over many months rather on a single day.’
John Ball, head of UK pensions at Towers Watson, said it was ‘unsurprising’ the regulator had not demanded a general hike in contributions when cash becomes available to companies, but said that despite this, maintaining current contributions in ‘real terms’, might still be too much for some firms.
‘Trustees have always recognised that contribution increases financed by cancelling dividends or investing less in the business have the potential to do more harm than good if this undermines the company's ability to compete and to raise capital in future,’ he said.
‘The regulator's acknowledgement that paying as much as possible into the pension scheme is not always the best thing for benefit security will help trustees continue to take a pragmatic approach where alternative uses for the money can be good for the sponsor's covenant.’
But he said there were ‘the usual ifs and buts’ – in particular in relation to the regulator stating that most schemes can afford ‘appropriate’ dividend payments, but these should reconsidered when there is a ‘substantial’ risk benefits won’t be paid in full. ‘Perhaps inevitably when it is trying to police a scheme-specific funding framework, it does not say anything useful about what must happen for these lines to be crossed.’
He added: ‘The regulator would be the first to say that its flexible approach to cash contributions is not mirrored in how it thinks liabilities should be measured. Its message is that companies should just record a big deficit and, if really necessary, take longer to pay it off.
‘In general, it is good that the regulator has encouraged trustees to think about the risks to their funding plan, how they might react if things do not turn out as planned and whether contingency mechanisms can be built in. However, it will be interesting to see how the regulator applies its comment that level of detail in contingency plans should be proportionate to the risk being taken, as so many different things could conceivably blow a recovery plan off course before the whole thing is reviewed again in three years' time.’
Mercer said the statement was helpful in providing further clarity about the regulator’s expectations when valuations are carried out. Dr Deborah Cooper said: ‘The statement implies that TPR might permit the elastic to be stretched a little further than before on condition that trustees consider what contingency mechanisms they may need to have in place if the elastic snaps. Current market conditions are accepted to be unusual, but may persist for some time yet.’
The consultancy said advisers should tell trustees to take an integrated approach to valuations by considering investment and employer risk together and by fathering evidence for any decisions taken.
‘Many tools are available for measuring risk, market impact and covenant strength, but none of these tools is clairvoyant,’ said Dr Cooper. ‘Although there is regulatory focus on the valuation process, a successful outcome requires judgement and regular monitoring of investment, liability and covenant risk.’
She added: ‘Trustees need to work with employers to enable outcomes that achieve an appropriate balance of interests between shareholders and scheme members. The Regulator needs to respect this balance also, in carrying out its role.’
Association of Consulting Actuaries’ chairman Stuart Southall said: ‘The ACA welcomes the confirmations of what the regulated can expect from the Regulator, although the undertakings stop short of promising consistency of approach or completion of reviews within commercially sensitive timescales.
‘The flip side of the acknowledgement that the use of cash in a business (including for dividends) might improve the employer’s covenant is surely that an ‘unresolved’ pension funding situation might damage the covenant, particularly for high profile quoted businesses.
He added: ‘Reducing and ideally removing delay or uncertainty in resolving funding situations is just as important and this is an area the Regulator needs to address.’