The Pensions Regulator (TPR) published its Annual Funding Statement for 2022 on 27 April 2022 (the Statement). We look at the key takeaways for trustees and employers of DB pension schemes.
The Statement provides an annual update on TPR’s views on:
- risk management practices;
- regulatory developments; and
- current issues facing schemes
which are expected to have a bearing on pension scheme management.
The Statement also sets out specific guidance on how to approach valuations under current conditions and contains tables setting out expectations for different schemes depending on the scheme’s funding position, covenant strength and maturity.
You can find a link to the full text of the Statement here. In this blog, we look at what TPR has identified as the current challenges for scheme funding and employer covenant and what trustees and employers could be doing to manage those risks.
As usual, the Statement identifies topical issues that trustees should be taking into consideration when assessing the potential impact on employer covenant and scheme investments. These are particularly relevant for:
- the so-called ‘Tranche 17’ schemes currently carrying out valuations (with valuation dates between 22 September 2021 and 21 September 2022); and
- schemes undergoing significant changes that require a review of their funding and risk strategies.
TPR advises trustees to consider the current and potential future impact of global events and economic conditions on their scheme and their employer covenant, including:
- high inflation;
- interest rate rises;
- higher global energy prices;
- the Russia-Ukraine conflict,
as well as the continuing effects of Covid and Brexit.
TPR advises trustees to consider the overall impact that current market events may have on the Employer’s business and categorise this in one of three ways:
- impact has been limited;
- impact has been material but trading has recovered or is recovering or impact is expected to be short-lived; or
- impact continues to be material.
Where impact has been limited, trustees are urged to try to reduce the length of recovery plans, particularly where there are concerns the scheme is being treated inequitably relative to other stakeholders. TPR reminds trustees to remain vigilant of covenant leakage, such as:
- shareholder distributions;
- cash pooling arrangements; and
- group trading arrangements.
Employers should be aware that when entering into valuation discussions, trustees may wish to explore options such as dividend sharing mechanisms and negative pledges.
According to TPR’s analysis, the aggregate funding level for all Tranche 17 schemes was ahead of that expected three years previously. Nonetheless, TPR warns trustees that their scheme’s funding position and covenant could change very quickly.
In the Statement, TPR encourages trustees to obtain specialist covenant advice, particularly if the covenant has been materially impacted by the current market events. It does, however, recognise that employers have a key role in the open and ongoing sharing of information with trustees of smaller schemes for whom independent covenant advice may not be readily accessible.
Trustees and employers should work together to understand key risks to their scheme and the effectiveness of their strategies to manage them, including:
- long term funding targets (LTFT) – although it is not yet a legal requirement, TPR recommends that trustees agree to a long term funding target with the employer now and set their journey plan accordingly. When setting their LTFT and journey plan, trustees should take into account the potential impact of interest and inflation rate changes;
- longer-term reliance on covenant – TPR encourages trustees to engage with employers to understand risks to the employer covenant over the journey to the LTFT and beyond, and consider, where appropriate, requesting downside protection from the employer;
- monitoring and contingency planning – trustees are reminded of the interplay between funding, investment and covenant and that it is good integrated risk management practice to monitor key risks against metrics for each of these and have contingency plans in place for when the metrics are breached;
- schemes in surplus – trustees of schemes that are now fully funded on a technical provisions basis should consider their liquidity needs after employer contributions reduce and factor this into their investment strategy and LTFT. Such trustees should remain focused on their end game strategy and may wish to discuss contingent funding contributions with employers, linked to funding and risk triggers.
Contingent funding plans can be a win-win strategy for schemes, providing downside protection to trustees and helping employers to guard against a trapped surplus. Our graphic (see below) sets out some of the more popular contingent asset options below.
Risks to the scheme and risks to the employer’s business are often connected by the same underlying factors, such as inflation, interest rates or climate risks. TPR encourages trustees to assess their impact on the scheme and the employer covenant in an integrated way and recommends scenario planning as a useful way to provide insights into the key aspects of funding strategies like de-risking, journey planning and contingency planning.