The Pension Regulator’s annual defined benefit funding statement

Rachel Graham

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The Pensions Regulator (TPR) has now issued their 2016 annual funding statement (“the Statement”) primarily aimed at Defined Benefit (“DB”) pension schemes undertaking valuations with effective dates in the period 22 September 2015 to 21 September 2016. The statement emphasises some key principles from their Code of Practice 3 for funding DB pension schemes, namely the expectation that trustees take an integrated approach to risk management and the importance of collaborative working between trustees, employers and advisers.

The Statement sets out TPR’s expected position of DB pension schemes with valuation dates in the period 22 September 2015 to 21 September 2016. TPR expects these schemes will have experienced most major asset classes having performed well over the period since their last triennial actuarial valuation. However, returns for some asset classes have been relatively flat or negative in the last 12 months.

TPR’s modelling suggests scheme liabilities are likely to have grown at a faster rate than their assets since their last valuation; this is as a result of the volatility in market yields and expectations for interest rates and inflation. This is expected to lead to funding strategies based on lower expected investment returns from most asset classes than in their last valuation. Trustees are advised to consider with their advisers their longer term view of risk and returns and how this is inter-related to their funding plans.

As a result, TPR expects most schemes will have a larger than expected deficit at their valuation date. Depending on the scheme valuation date and their hedging strategy – scheme deficits are estimated to be in the region of 20-35% higher than they previously were. TPR expects that this will lead to changes to existing recovery plans for which trustees and employers will need to assess the associated risks and ensure it is consistent with their risk tolerance and their other risk management plans. TPR’s analysis of sponsoring employers suggests that if a scheme chooses to maintain their existing recovery period end date following their valuation then the median increase in deficit repair contributions (DRCs) is  expected to be in the region of 75-100%. This may or may not be affordable to sponsors and will depend on a number of factors such as the sponsor’s future plans for sustainable growth and strength of the sponsor covenant. TPR expects trustees to seek higher contributions where there is sufficient employer affordability .

Worryingly, around 45-50% of schemes are expected to need to increase DRCs by more than 100% in order to keep the same recovery plan end date. Where the current recovery plan period can not be maintained other adjustments will be required in order to put an appropriate recovery plan in place; for example by extending the recovery plan length. The trustees and employers would need to consider the potential impact of taking on this additional risk.

TPR also outlines recent developments affecting valuation assumptions. This includes;

  • reduced longevity under the 2015 version of the Continuous Mortality Investigation model (CMI2015). Being based on the most up to date analysis, this may be proposed by the scheme actuary. Perhaps surprisingly, TPR is advising some caution and suggesting trustees liaise with their advisers to understand the effects if this reduction to life expectancies is reversed in future.
  • emphasis on valuation assumptions being evidence based. TPR believes that there is very little evidence which would support trustees adjusting their assumptions regarding transfer take ups in light of ‘pension freedoms’ but it may be appropriate in some cases to take some account of this.
  • appropriately setting contribution rates for future accrual in light of reduced expectations for future returns.

TPR’s proportionate approach to risk management is evident throughout the Statement. Trustees are encouraged to understand their scheme’s exposure to risk across covenant, funding and investment and put in place an integrated strategy to manage these risks. Additional practical guidance from TPR on setting an investment strategy is promised later this year and will be welcomed by trustees.