2017 Annual Funding Statement - Do. It. Right.

The Pensions Regulator (TPR) has just published the 2017 Annual Funding Statement for defined benefit pension schemes.  There is a very clear message that is coming through to all of us trustees:  Do.  It.  Right.

The statement is primarily aimed at trustees undertaking valuations with effective dates between 22 September 2016 and 21 September 2017.  TPR has taken a slightly different approach this year by identifying different groups of schemes that have been impacted in different ways by changes in market conditions over the last three years.  Interestingly, TPR hints that there is analysis that supports their conclusions for each of the groups but then states that the analysis will be published separately after the General Election.  So, we will have to wait a few more weeks to see that as nobody wants DB scheme funding to distort the outcome of the election.

TPR recognises that most schemes will have seen their funding position deteriorate over the last three years.  Trustees will find that, although assets may have performed well, liabilities have performed even better and so deficits have grown.  That being the case, trustees should now be thinking about invoking their contingency plans and that is where the statement categorises our schemes into three groups:

•    Strong employers with good funding position – carry on as you were;
•    Strong employers with poor funding position – trustees to seek higher contributions now; and
•    Weak employer but may be part of a larger although no formal support exists – trustees to seek legally enforceable support and seek every opportunity to reduce risk.

I am a trustee to quite a few schemes now.  I am pretty sure that not all will fall into the groups above (what about a weak employer that is not part of a wider group?).  TPR recognises that there are some schemes that have a weak sponsor and which may not be able to adequately support the scheme; stating that five percent of all schemes fall in to this category.  This seems low to me.  The statement provides trustees with specific guidance for such schemes (referred to as “stressed schemes”).  Trustees will need to “fully evidence” they have taken appropriate measures such as ensuring the scheme ceases future accrual, consider the covenant strength and restricting any dividend payments, maximise non-cash support from the employer and the wider group (if there is one), identify and control wider risks and of course and, finally, the nuclear option – wind-up the scheme.

TPR also focusses on the discount rate assumption.  There is recognition of the fact that methodologies are being reviewed by trustees as a consequence of the very low gilt yields.  Trustees should take advice on any methodology changes and then document them.  Even if trustees stick with their old “gilts +” method then they should document why they think that approach remains appropriate.  My view is that the regulations make this clear.  Trustees must use one of two methods:

I.    A pure gilt yield approach; or
II.    A discount rate based on the scheme’s investment strategy.

I am not sure where gilts + sits within these two permissible approaches – do actuaries even think about this properly or do they just do what is easiest?

tPR recognises that many DB schemes are now maturing and are becoming cashflow negative.  In my view, this will become a dominant consideration in the UK DB space over the next ten years and this will influence heavily the investment decisions trustees make.  TPR makes a definite nod to the future by saying that trustees should monitor their cashflow requirements, have a cash management policy and monitor their cashflow requirements.

No statement is complete without the reminder about managing risks and using an integrated risk management approach to the valuation process(and quite rightly so).  This one does not disappoint and uses strong language to steer trustees where their scheme’s funding position has deteriorated for two or more valuations. Trustees should take “decisive action” to arrest the decline in the funding position and turn it around.  Underpinning this decisive action is the fair treatment between schemes and shareholders and there is a reminder to trustees that they should not allow priority to dividend payments ahead of the financial health of the pension scheme.

There are also a couple of important points on investment that the Regulator makes.  Firstly, trustees are reminded not to take excessive risk in their investment strategy, especially where the employer’s covenant is weak or cannot support a high lever of risk (remember integrated risk management?).  Secondly, those schemes that had protected themselves from interest rate risk will have performed well over the last three years.  LDI strategies have performed well with their values rising and investment managers subsequently making payments in to the schemes asset portfolio.  I do wonder, though, whether TPR will be making similar noises if and when interest rates rise and investment managers are making cash calls, such that pension schemes are forced to sell some of their assets to pay the managers.  That’s an interesting one.  Finally, a reminder to trustees of small schemes, that the market has moved on and to revisit historic decisions on amending funding strategies as the market has opened up significantly.  This seems a key point as in our experience, small schemes have been slow to implement LDI and thus will have had difficult triennials.

So, in summary, there are some old messages and some new messages in this statement.  The familiar old messages are about integrated risk management and making sure you collect as much as you can from sponsor either as cash or contingency funding.  The new messages include the categorisation of schemes, the discount rate methodology and scheme maturity.  As usual, there are many, many factors for trustees to consider when they complete their valuation this year.  TPR is watching them.  So they had better make sure they do it right.