In its 2020 Annual Funding Statement issued yesterday, the Pensions Regulator walks a fine line between urging trustees to give sponsors sufficient breathing space to help them survive the current economic crisis whilst urging trustees and sponsors not to be deflected from their long-term goals.
The statement will offer comfort to sponsors who are looking to reduce or defer deficit contributions in the short term in order to preserve cash. However, it will also place constraints on corporate activity and result in more complex funding arrangements and triggers having to be negotiated.
While the statement is dominated by themes related to COVID-19, the Regulator reminds trustees not to forget the potential impact of Brexit on their scheme and sponsor with the transitional period following the UK's departure from the EU set to end on 31 December 2020.
Key messages
- The Regulator recognises that COVID-19 will have negatively impacted the financial position of many schemes and sponsors, although it notes that the impact will vary. Schemes with valuations with effective dates at the end of March or early April 2020 which are unhedged and invested heavily in equities will have been particularly hard hit. As will sponsors in sectors such as leisure, travel and hospitality.
- The Regulator urges trustees and sponsors to work collaboratively and acknowledges that agreeing valuations with an effective date in March or April this year will be challenging.
- It recognises the need for sponsors to be given time and space to recover. However, the Regulator expects the interests of DB scheme members to be protected and for deficit recovery contributions to increase as corporate performance and cash flows improve.
- The Regulator expects distributions to shareholders to have ceased and intra group transfers to be restricted where deficit contributions have been deferred and for these restrictions to remain in place until deficit contributions have resumed.
- Whilst acknowledging the short term challenges faced by trustees and sponsors the Regulator does not want them to lose sight of the long-term goals for their scheme.
- It is not possible to predict how long the current environment will continue, or what further impact it will have on pension schemes and the businesses supporting them. The Regulator will continue to monitor the situation and will issue further guidance as necessary.
Relevant schemes
The Regulator’s Annual Funding Statement is particularly relevant to schemes with valuation dates between 22 September 2019 and 21 September 2020 (Tranche 15, or T15 valuations), as well as schemes undergoing significant changes that require a review of their funding and risk strategies.
It sets out:
- specific guidance on how to approach the valuation under current conditions;
- what the Regulator expects from trustees and sponsors; and
- what they can expect from the Regulator.
Impact of recent events on schemes
Approximately 25% of Tranche 15 valuations take place at dates around 31 December 2019 and a little over 50% take place at or near 31 March 2020. Funding positions will inevitably vary depending on the exact valuation date - this year more so than others.
The Regulator’s analysis indicates that, as at 31 December 2019, there was a general improvement in funding levels compared with three years previously, reflecting better than expected investment performance. Schemes that had hedged interest rate and inflation risks appeared to be above target while others were marginally below.
The analysis also shows that there is a significant variation in the funding position of schemes as at 31 March 2020. Schemes with low exposure to equity markets and good levels of hedging remain above target or are marginally below, despite the market conditions. At the other end of the spectrum, a smaller proportion of schemes that were heavily exposed to equities and not sufficiently hedged against interest rate risk have experienced a sharp fall in funding levels.
Therefore, trustees will need to consider the particular position of their own scheme and sponsor.
1. Scheme specific considerations
Post valuation experience
The Regulator does not expect schemes that are close to completing their valuations to take into account post-valuation experience to change their valuation assumptions. However, it does expect trustees to take this into account in their recovery plans, with a focus on what is affordable for the sponsor.
Schemes with valuation dates around 31 December 2019 or earlier should consider taking account of post valuation experience, especially the impact on the scheme's assets and liabilities of the significant changes in market conditions since the effective date of the valuation and the impact on the sponsor covenant. Post-valuation experience must be applied consistently, which means taking account of both positive and negative experience. This is particularly relevant where trustees are also considering requests to take account of negative changes in the employer’s affordability.
Bringing forward a valuation date
It could be that trustees of schemes with valuation dates around 31 March 2020 consider bringing forward their valuation date (on their own initiative or at the request of their sponsor) due to the unusual markets conditions at that time. The statement makes it clear that any decision to change the valuation date should only be taken after the trustees have obtained legal and actuarial advice and trustees should expect the Regulator to question their reasons for agreeing to any change. Furthermore, it states that trustees should consider this very carefully and only agree to this where they believe such an option is in the best interest of their members having regard to the impact of any such change on member security, particularly if the current conditions prevail for a long period.
Calculating technical provisions
The Regulator recognises the challenges that will be faced in setting valuation assumptions given that many trustees will not have sufficient information to form a reliable view on long-term future returns from their scheme's investments. Many will face similar issues in respect of their sponsor covenant and affordability. Consequently, whilst trustees should take preliminary steps to form a view on the key assumptions that will be used in their valuations and to consider the rate and shape of the future recovery, they ought to delay taking decisions about their technical provisions assumptions until more clarity emerges, although there is no mention of relaxing the 15 month timeframe within which valuations must be agreed. The Regulator also encourages trustees to make use of scenario planning to inform their decisions, to assess risks and to set up mitigation strategies.
Recovery plans and affordability
The current economic downturn will place an even greater emphasis on affordability than usual when trustees and sponsors are seeking to agree a recovery plan. The Regulator’s statement recognises this. However, it notes that the financial impact of COVID-19 will vary depending on the nature of a sponsor’s business and it urges trustees to carry out additional due diligence to form their own assessment of this.
Where deficit reduction contributions are deferred or reduced to give sponsors time to recover, the Regulator expects trustees to ensure that those contributions increase in line with the recovery of the business. Additional contributions could also be linked to investment performance. Therefore, suitable triggers will need to be negotiated as part of any recovery plan.
For more information on deferring deficit recovery contributions check out our previous blog.
Shareholder distributions and intra group transfers
Where deficit recovery contributions have been deferred, the Regulator expects distributions to shareholders to have ceased and intra group transfers to be restricted. It doesn’t expect shareholder distributions to recommence until liquidity and affordability has been largely restored and deficit contributions have resumed. Recovery plans should reflect this.
2. What’s expected of trustees
Long-term funding target
Whilst the Regulator recognises the need for valuations and recovery plans to take account of the impact of COVID-19, it does not want trustees and sponsors to lose sight of their scheme’s long term goals. In line with the proposed new funding requirements contained in the Pension Schemes Bill and the principles that will underpin the Regulator’s new funding Code, the Regulator expects trustees and sponsors to set a long-term funding target for their scheme, if they have not done so already. They should also put in place a journey plan setting out how that target will be reached and providing for the scheme’s technical provisions to increase over time until the scheme reaches its long-term objective.
Covenant assessment
Trustees should consider getting independent specialist advice to support their assessment of their sponsor covenant. This is particularly important where the covenant is complex, deteriorating, or where the scheme has a high degree of reliance on the covenant, for example because it has a large deficit. Trustees should only undertake their own covenant assessment where they have sufficient experience. Where specialist advice is not sought, trustees should keep a full audit trail of their decisions and they should record their reasons for not taking professional advice. The Regulator emphasises the need for objectivity from trustees when assessing their sponsor covenant and reminds trustees of the need to identify and manage any potential conflicts of interest.
As well as taking account of the impact of COVID-19 on the sponsor covenant, any assessment should also consider the impact of other factors, such as the potential impact of the different outcomes of the future trade negotiations between the UK and the EU. This should include the possibility of the transitional period ending without agreement on 31 December 2020 and the UK trading with the EU on World Trade Organisation terms after that date.
In normal times the Regulator would expect trustees to closely monitor their sponsor’s covenant strength. The Regulator expects the frequency and intensity of monitoring to be significantly increased at the current time, until covenant visibility and strength is restored.
Covenant leakage
While the Regulator recognises the need for trustees to be supportive of sponsors under financial pressure, it urges them to be vigilant of covenant leakage which reduces the ability of the sponsor to support the scheme. Alongside the payment of dividends, other forms of covenant leakage highlighted by the Regulator include:
- cash pooling and inter-company lending arrangements;
- group trading arrangements;
- management fees, royalties and similar charges;
- transfers of business or assets at undervalue; and
- excessive executive remuneration.
For a healthy sponsor with short recovery plans, such arrangements are unlikely to be a problem. However, where a sponsor is seeking a long recovery plan because of limited affordability, trustees should ensure the sponsor’s ability to support the scheme is not constrained by covenant leakage to the wider group and should seek appropriate safeguards to prevent this.
Managing risks
The Regulator expects trustees to continue to focus on the integrated management of their scheme’s funding, investment and covenant risks. The statement contains a series of tables which identify the key risks that the Regulator expects trustees to focus on and associated actions. These vary depending on a scheme’s funding position, covenant strength and maturity. Although the content of the tables is identical to last year’s statement, trustees may need to reconsider, together with their advisers, which table is relevant for their scheme in light of recent events.
3. What trustees and sponsors can expect from the Regulator
Although the general tone of the statement offers support for sponsors in financial difficulty, it closes by making clear that the Regulator will continue to examine the overall risk profile of valuations and funding arrangements that it receives. It also reminds sponsors and trustees that it has the power to impose its own technical provisions and/or recovery plan on a scheme where sponsor and trustees fail to reach agreement or where the agreement that is reached is deemed unsuitable.
New DB funding Code
Finally, the Regulator confirms that the second phase on the Regulator’s consultation on the new funding Code will not now take place until early 2020 with the new Code not likely to come into force until late 2021 at the earliest.
If you have any questions about the impact of the Annual Funding Statement on your scheme or you have any particular concerns about your scheme or sponsor, please contact us.
You can find out more about the impact of COVID-19 on pension schemes and how trustees and sponsors are responding on our UK pensions blog.
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Disclaimer
The articles published on this website, current at the dates of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action.