Pensions Regulator maintains stance on defined-benefits funding

In its first annual financial funding statement, the Pensions Regulator sets out its views on the approaches to the valuation process that it considers acceptable in the current economic environment. We examine the regulator's statement together with first reactions to it.

On this page:
Quantitative easing
Box 1: First reactions
Risk management
Extending recovery plans
Mixed reactions.

Key points

  • The Pensions Regulator has published its first annual funding statement setting out its expectations in respect of scheme valuations undertaken in the present economic climate.
  • The statement applies to defined-benefit scheme valuations with effective dates between September 2011 and September 2012.
  • It seeks to reassure schemes that there is sufficient flexibility within the system to cope with current uncertainties in financial markets.
  • The regulator uses the statement to set out its views on the effect of quantitative easing on pension funds and how schemes should deal with the issue of the resulting falling gilt yields.
  • The statement stresses the need for trustees to adopt an integrated approach and to have a robust financial management plan that includes contingency mechanisms to address risks.
  • The regulator signals its willingness to consider longer recovery plans where the employer's covenant has significantly weakened if there is sufficient justification.

As the country officially falls yet again into recession, the Pensions Regulator has published its first annual funding statement1 setting out its expectations in respect of defined-benefit (DB) scheme funding. The statement is aimed at trustees and employers of DB schemes whose scheme valuations have effective dates falling between September 2011 and September 2012. The regulator estimates that this will be about one-third of the 6,500 DB schemes in the country. It points out that the statement will be relevant to all trustees and employers with DB schemes as it provides an indication of the regulator's views on a number of key issues affecting the valuation process in difficult economic times.

This is the first such guidance that the regulator has issued on the topic since it published three statements in quick succession when the current economic crisis commenced in 2008. However, the accompanying press release suggests that in future a statement will be issued each year.

Box 1: First reactions to the pensions regulator's annual funding statement

"Broadstone welcomes the fact that the regulator's funding statement has resisted calls to give trust­ees a carte blanche to fudge the assessment of their scheme deficit based on subjective views about gilt yields. It is about time that scheme sponsors stopped treating pension scheme trustees as a soft target - they need to wake up and realise that repayment of pension scheme debt is not somehow optional."
John Broome-Saunders, actuarial director, Broadstone Pensions & Investments

"The regulator's stance seems to recognise the role luck plays in the timing of scheme valuations. It's questionable why market values at a current point in time should be baked into a recovery period which stretches several years. [Its] emphasis on flexibility should take some of the pressure off companies, helping to ensure they don't divert more cash than necessary into pension schemes at a time when this funding could be needed elsewhere in the business."
Jeremy May, pensions partner, PricewaterhouseCoopers

"Although this was originally billed as a response to current market conditions and quantitative easing [QE], in practice there is no olive branch for employers, and the regulator has significantly raised the stakes for both trustees and sponsors. While the industry was crying out for easements to reflect gilts markets and QE, instead we have a new set of rules and constraints." 
Mike Smedley, pensions partner, KPMG

"At first glance this may seem like another unwanted imposition on hard-pressed trustees. But we are increasingly seeing that well-developed financial management plans are starting to address the 'what if' type of questions on whether outcomes are in line with expectations. The regulator implies this is a job for trustees alone. I believe that for it to be effective it must be a well-reasoned and robust discussion between employer and trustees."
Kevin Wesbroom, managing principal, Aon Hewitt

"The flipside of the acknowledgement that the use of cash in a business (including 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. 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."
Stuart Southall, chair, Association of Consulting Actuaries

The statement indicates that, as schemes should have undertaken at least two valuations under the scheme funding regime, a "high standard of proficiency in its application is implied" in the statement. It continues that schemes that follow the guidance are "more likely to reach funding agreements that the regulator finds acceptable without the need for regulatory involvement".

Quantitative easing

The Pensions Regulator starts from the basis that most schemes should be able to meet their pension commitments with only small changes to their current funding regimes. It suggests that there is sufficient flexibility within the funding framework to address the current economic challenge to achieve an "appropriate and balanced outcome".

However, it notes that there has been considerable volatility in deficits at different effective dates and that this problem has been compounded by the Bank of England's quantitative easing programme, which has driven long-term gilt yields down to historic lows (these yields are used to discount liabilities). There has been pressure on the regulator from schemes to allow them to take account of the fact that gilt yields should start increasing at some time in the future. The regulator rejects these demands, pointing out that there is no certainty that gilt yields will return to more "normal" levels or about what "normal" might be. It also notes that smoothing the discount rate would be inconsistent with the requirement to value assets on a current market-value basis.

It recommends that, where schemes have strongly held views about future financial market conditions, rather than incorporating increased discount rates in their valuations, they should accommodate them in recovery plans, and include mitigation should their expectations turn out to be false. Not unexpectedly, the CBI has reacted against this, stating that the effects of quantitative easing should be allowed for in valuations as the increases in deficits have increased demand for money from "hard-pressed" employers and will impact on job creation and ultimately on credit ratings.

Other commentators have taken the view that the regulator's stance is correct, as there is a strong possibility that the Bank of England will have a further round of quantitative easing.

Risk management

The Pensions Regulator makes a point of commenting that it expects valuations to be completed on time. It also stresses that trustees should not select an earlier valuation date than they would otherwise have used to reflect better economic circumstances. However, trustees may use actual post-valuation experience if appropriate.

The regulator expects trustees to have a complete financial management plan that draws together actuarial, investment and covenant information and advice. It also expects trustees to document their considerations and to be able to explain their decisions based on their financial plans.

In addition, the regulator states that trustees should undertake contingency planning in case the actual position does not reflect the assumptions made. Furthermore, it advises that the level of detail in such plans should be "proportionate to the risk being taken". It warns that where it identifies schemes that have not followed the statement, it will look in depth at these financial plans and at the contingency mechanisms that have been put in place to address risks.

Extending recovery plans

One of the more welcome aspects of the regulator's statement is that it seems to signal its willingness to accept longer recovery plans where the employer's covenant has weakened significantly as a result of the economic downturn. However, it states that it will require "documented justification" in circumstances where deficit contributions are reduced or there is a material extension to the recovery plan end date.

The regulator also asserts that its analysis shows that in most cases the employer should be able to maintain deficit contributions in real terms. But it recognises that employers have many financial demands on them at present and comments that the pension scheme should be "treated equitably" among such demands. Where the business is sitting on cash, which could be used to pay "affordable" pension contributions but is not, it expects it to be used to improve the employer's covenant. There is a warning that if cash is being used to prop up dividend payments at the expense of the pension scheme, then such payments may need to be "reassessed" in the light of the company's obligation to the pension scheme.

Mixed reactions

The initial views of the pensions industry, some of which are reproduced in the accompanying box, have been somewhat mixed. Some commentators have welcomed the statement, believing that it will be of great help to trustees and employers during the economic downturn. Others believe that the approach outlined in the statement is overly rigid, especially in respect of quantitative easing, and does little other than impose more regulation on trustees. Joanne Segars, chief executive of the National Association of Pension Funds, probably reflecting the views of many in the industry, comments that while the regulator's stance is helpful "we hope that its dealings with pension funds and their employers are consistent with what it has outlined."