Time to reassess pension scheme ‘goals’

by Matthew Masters   •  
Blog

Ultimately, the goal of a pension scheme is to pay pensions to savers. 

The Pensions Regulator (TPR) would like this done in a risk-controlled way, understandable when you stop to consider that TPR is effectively overseeing £2trn of UK corporate sector defined benefit (DB) liabilities. Scheme sponsors, on the other hand, will wish to avoid over-funding, while simultaneously satisfying trustee and TPR requirements.

In January 2021, three documents were released relating to the long-term funding of DB pension schemes:

  1. On 11 January, a “Report of the target end-states for DB pension schemes” was presented to the Institute and Faculty of Actuaries. This paper set out issues trustees, employers and their advisers should consider when addressing whether their Target End State should be low dependency, buyout or transfer to a superfund.
  2. Also on 11 January, a paper entitled “Time horizons and the employer covenant” was issued by the Employer Covenant Practitioners Association (ECPA), examining the importance of understanding employer longevity as part of the evaluation of the employer covenant. 
  3. Then, on 14 January, TPR published an interim response to its first DB funding code consultation, which aimed to scope out what the revised DB funding code may look like under developing legislation. By way of reminder, the Pensions Schemes Billwill introduce a requirement for trustees to set a long-term objective and to document this, alongside their approach to funding and risk management, in a “Statement of Strategy”.

These emphasise the fact that in the midst of economic volatility, and despite the understandably natural approach to focus on dealing with today’s problems, pensions are a long-term contract and require long-term management.

Employer longevity

It is a well-documented fact that DB pension schemes are maturing, with many shifting into cashflow negative mode. This increases the importance of establishing whether a sponsor will still be around and able to make any contributions that might be required going forward. Prudence suggests that the risks run by a pension scheme, that are being supported by a sponsor, should be managed so they reduce over time. 

Pension schemes with a single employer (or even small numbers of employers) are particularly susceptible to high levels of concentrated exposure. Black swan events, such as Covid-19, can lead to rapid deterioration of what may have previously been deemed a very solid covenant. Indeed, EY recently published research showing that 62% of listed DB pension scheme sponsors issued profit warnings in 2020, with current pressures on cash flows exacerbated by the additional need to fulfil pension promises.

Looking longer-term, it is highly likely that a DB pension scheme will see a change in its corporate sponsor over its multi-decade lifetime, whether through M&A activity, restructuring, change in business model or liquidation. By way of illustration, none of the original constituents of the FTSE30, created in 1935, has continued in the same form through to today. 

Consequently, longevity of a sponsor, alongside legal obligation and financial capacity, should help inform trustee decision making. There are a number of tools that can assist covenant providers in assessing longevity, including consideration of the employer’s competitive market position, its scale and market power, ability to invest, and management track record.

Three key take-aways for pension trustees

Against the backdrop of these findings on employer longevity, I have set out below three key take-aways that pension trustees should be considering in light of recent developments.

  • Think long term. 
    • The long-term objective of your scheme should be front and centre, not simply getting through to the next triennial actuarial review. Investment and funding strategies ought to work together to deliver the best member outcomes. 
    • A journey plan should be specific. If you’re looking towards a low-dependency outcome, define this clearly.
    • Involve the sponsor. For example, it may be beneficial to include rule amendments as part of an agreed long-term funding package to protect their interests should a confirmed buy-out surplus arise.
  • Be realistic. 
    • For example, it can be unhelpful to focus on a Target End State (TES) strategy which has a primary objective of buy-out where that may not be affordable within a reasonable timeframe, regardless of what sponsor funding might be available or what investment returns are realistic. Doing so could result in a sub-optimal strategy for the scheme. 
    • Choose a sensible timeframe and review your TES periodically – it can be changed as circumstances develop.
    • Understand genuine constraints. For example, company accounting requirements can create tension between reasonable trustee activities, such as purchasing bulk annuities, and the impact upon the sponsor’s accounts.
    • Acknowledge that in some cases there may be no best strategy, simply a least bad one.
  • Have a back-up plan. 
    • Having a plan is a great first step. Having a plan B, in case of employer distress for example, is also sensible. Too many schemes, while good at identifying risks, do not agree the steps they should practically take if those risks are realised.
    • Mitigation options could include increasing the target investment return; introducing new or alternative contingent assets; extending the timescale for reaching, or altering, the TES (e.g. from buy-out to low-dependency, or to a weaker form of low-dependency); additional sponsor funding; initiating member option exercises; or constraining sponsor dividends.

With 2021 looking likely to set as many, if not more challenges than 2020, trustees should look not only to ensure that their goals are fit for purpose, but that they can be adapted to change as and when required.

Further reading

Your Quarterly Pensions Update Quarter 2 2021

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The RPI/CPI debate – A ‘Refreshing’ Decision?

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