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On April 5, 2018, the Pensions Regulator (TPR) published its latest annual funding statement. The statement is aimed at trustees and sponsoring employers of defined benefit (DB) schemes with valuation dates between September 22, 2017, and September 21, 2018 (referred to by TPR as tranche 13 schemes). However, given its wide implications, the statement is relevant to all DB schemes, and its contents should be noted particularly where schemes face significant changes and, as a consequence, require reviews of their funding and risk strategies.
While TPR’s analysis suggests marginally improved funding levels for tranche 13 schemes compared to three years ago at the time of their last valuations, hedged schemes will generally have fared better. The statement flags concerns about what TPR describes as the growing disparity between dividend growth and stable deficit reduction contributions (DRCs).
The statement should be read in conjunction with TPR’s code of practice on scheme funding, which will be updated “over the next two years” and which, according to the recent White Paper on DB scheme sustainability, may become mandatory.
This briefing looks at the key messages from TPR in the 2018 statement, compares them with some of the themes in TPR’s earlier statements, and suggests some key actions for trustees and employers engaged in or approaching a valuation.
Of late, the pensions landscape has been dominated by corporate failures: TPR’s 2017 statement followed a Parliamentary enquiry into the collapse of BhS; the 2018 statement follows a Parliamentary enquiry into the collapse of Carillion. It is therefore unsurprising that TPR’s key messages for this year centre on:
These principal areas are each considered separately below.
As in the 2017 statement, TPR has segmented schemes according to sponsoring employer characteristics (strong, tending to strong, or weak). However, the 2018 statement places more emphasis on covenant strength and TPR has also split weaker employers into three subsets, while the 2017 set out only one such category. TPR has provided in tabular form what is expected of trustees, depending on the group into which their scheme falls:
In the 2018 statement, TPR actively encourages trustees of schemes with strong employers to seek additional financial support where a sufficiently robust employer may be in a position to provide it. This is a change in emphasis from the 2017 statement, which focussed more on stressed situations. Those with weaker employers should bear in mind that TPR could well seek confirmation of any measures taken to improve their scheme’s position and members’ benefit security.
TPR is concerned about the “growing disparity” between dividend growth and stable DRCs. It states that a strong covenant should not of itself prevent trustees from insisting on higher contributions where the employer can afford them and, where dividends are disproportionate to contributions, TPR will consider that affordability is not an issue. There is no defined dividend/contribution ratio but the statement highlights that the trustees’ key objective is to ensure the scheme is able to pay benefits as they fall due and, with this in mind, TPR expects robust negotiations to achieve a fair deal for the scheme.
Trustees should also be alert to other forms of “covenant leakage” (that is, value leaving the sponsoring company) when considering the affordability of contribution payments and fair treatment of the scheme. Alternative types of covenant leakage could include intra-group loans, intra-group transfers of business assets at below market value and, for some smaller employers, high levels of executive remuneration. TPR’s view is that employers with weak or tending to weak covenants should normally retain cash within the company to fund sustainable growth and any pension deficit in preference to paying dividends.
It is unsurprising in the light of recent high-profile corporate failures that TPR is placing greater emphasis in this statement on what it considers to be the rightful place of deficit funding in the priority order of allocation of the employer’s financial resources. Trustees who fail to take a strong stance in their funding negotiations with the scheme sponsor may be called upon to explain their actions where recovery periods are considered by TPR to be too long or where dividend payments are seen as disproportionately generous.
In the 2018 statement, TPR builds on one of its central themes of recent years – that of the integrated management of three key risks; investment risk; funding risk and covenant risk (IRM). Trustees should take a balanced approach in monitoring risks and tailor their actions to suit the scheme’s circumstances. However, scheme size should not be a barrier to, or an excuse for, poor risk management or scrimping on adviser fees. Trustees, even those of smaller schemes, should work with their advisers to manage and prioritise risks. They should use appropriate tools, including risk-attribution charts, stress tests and scenario-planning exercises, examples of which are available in TPR’s quick guide to IRM and also the DB scheme investment guidance. Short term risks, such as a downturn in the employer’s business, should also feature on the trustees’ radar.
TPR states that effective IRM requires documented and workable contingency plans. Its view is that the best protection for schemes lies in contingency plans setting out legally enforceable rights where possible, such as those over secured assets. Where this is not possible, trustees should at least agree the actions to be taken if identified risks materialise. Where trustees are not satisfied that they have a reliable, legally enforceable contingency plan, they should consider a different overall strategy which leaves the scheme less exposed.
TPR’s approach on contingency planning appears less prescriptive than that in the 2017 statement, in which it advocated that all schemes should put in place contingency plans “which should be legally enforceable”. Trustees are expected to work with the employer in a collaborative fashion to assess how and what form of support could best be provided to the scheme.
The statement highlights several other areas of risk, which are considered below.
TPR’s future approach will be tougher and it intends to increase its level of supervision. This is a developing area and it will be interesting to see how the promised newly revised funding code of practice, to be produced “over the next two years” in the light of the DB White Paper, will address funding and valuation issues. It is clear that TPR will fine trustees for late valuations if “reasonable” steps have not been taken, and trustees should ensure that TPR is kept informed if they are at risk of missing the statutory deadline. That said, the prospect of a late valuation should not be cited as an excuse for trustees’ acceptance of a poor scheme funding deal from the employer.
As for transfer values, there is obvious concern about the appropriateness of some transfers (which is unsurprising, given the FCA’s recent surveys). Trustees should remain vigilant and highlight to TPR or the FCA any concerns they may have about member transfers.
TPR’s intention to seek documented evidence of the advice trustees have taken will enable it to intervene promptly where actions are taken which are not considered to be in members’ interests. Using its powers under section 231 of the Pensions Act 2004, it is possible for TPR to direct how a scheme’s technical provisions should be calculated and how (and over what period) its deficit should be funded. Although TPR has not actually used these powers to date, the statement says they could be implemented in some cases which are currently under consideration. The approaches used can vary from one-to-one supervision through to the use of an improvement notice or a full anti-avoidance investigation. A proactive approach has been taken in respect of small schemes, with TPR contacting those affected.
TPR confirms that its proactive casework has increased by 90 per cent and it warns that if a skilled person report is commissioned (under section 71 of the Pensions Act 2004) it may well require the employer or the trustees to bear the cost of producing that report.
The 2018 statement contains no fundamental changes in approach but the focus has switched from “stressed schemes” in earlier statements to strong covenants in the current publication. Even schemes with strong covenants are encouraged to strengthen their technical provisions and shorten recovery plans where possible. There is increased emphasis on contingency planning and, where covenants are weak, trustees need to manage the associated risks proactively.
It is possible that there may be significant changes in the revised DB funding code as the White Paper suggested that it may become mandatory. There is even a hint that TPR may be considering introducing some sort of formula for the calculation of the dividend/contribution ratio in future.
The 2018 statement highlights the importance for trustees of using documentation to evidence decision making, and such evidence may well be scrutinised by TPR in the event of funding difficulties, or risk to the financial sustainability of the sponsor.
TPR is keen to confirm that it will not hesitate to use its powers where necessary but still emphasises a collaborative approach between trustees and employers. For schemes currently carrying out or nearing a valuation, trustees would be well advised to consider the 2018 statement carefully, and a change of strategy might be required to avoid the possibility of TPR scrutiny.
View the funding statement.
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