For companies tackling a defined benefit (DB) funding valuation in 2022, it is helpful to start with the Pensions Regulator’s 2022 Annual Funding Statement (AFS).

This contains many of the themes that are familiar from recent TPR guidance but there are also lots of nods to the current backdrop, with the Russian/Ukrainian conflict, the lingering effects of Covid-19 and Brexit being notable themes. The challenges of high inflation, greater volatility in the investment markets and uncertain longevity all feature amongst the key issues to wrestle with. The key emphasis for trustees is on understanding how their scheme’s sponsor is coping, noting some businesses and sectors will be impacted more significantly by recent events. It is therefore vital that companies are proactive in briefing the trustees on covenant considerations.

The Pensions Regulator has renewed its drive for an equitable treatment of pension schemes relative to shareholders. In its 2022 AFS, shareholder distributions are viewed as inconsistent with reducing (or deferrals of) contributions and TPR indicates they should only exceed deficit recovery contributions if the pension scheme has a strong funding target and a relatively short recovery plan (under 5 years is given as an example). Where schemes have recently achieved full funding, or are close, then the focus should be on developing long-term plans and managing ongoing risks through contingent funding plans (e.g. to switch contributions back on if funding deteriorates).

With that backdrop, here are 5 tips that could help achieve a smooth funding discussion with your trustees.
 

1. Focus on the long-term strategy

Whether driven by the new funding code (more on this below) or the maturing nature of DB schemes, a focus on the long-term funding and investment strategy has never been more important. With most schemes experiencing an improved funding position following the recent rise in gilt yields (particularly on an insurance buy-out basis, as liabilities do not tend to be fully hedged on this basis), the whole industry is talking about “endgame” strategies and the importance of knowing the ultimate plan for discharging a scheme’s liabilities. A triennial funding valuation is an opportune time to develop that plan.

For sponsors, it’s critical to have a clearly articulated long-term strategy, for two reasons:

1. how can the company judge the appropriateness of a particular funding plan without seeing how it fits into a long-term strategy for managing the scheme’s liabilities?
2. experience shows that it is far easier to get trustees on board with a short-term funding proposal when it makes sense relative to a long-term strategy.

So, when approaching a 2022 valuation, start with the long-term strategy.

Member options and risk transfer solutions are key parts of a long-term strategy, and it’s important to firm up views on these areas as soon as possible, because:

• member options, such as pension increase exchange (PIE), can be intrinsically linked to decisions around how to implement GMP equalisation, for example the method of equalisation and the extent of data cleansing work; and a decision to use risk transfer solutions will have a material impact on the future development of the funding and investment strategy. It will also affect operational projects, in particular GMP equalisation and other data management work.
• a decision to use risk transfer solutions will have a material impact on the future development of the funding and investment strategy. It will also affect operational projects, in particular GMP equalisation and other data management work.

2. The new funding code is relevant

Whilst the Pensions Regulator’s new funding code is now not expected to come into force for valuations with an effective date before September 2023, it makes very little sense to agree a funding framework in 2022 without understanding how it will work with the new code in 2025. In practice, this means:

• developing (at least for company purposes) an appropriate long-term objective;
• considering the level of investment risk being taken and the role of assumed asset outperformance in the recovery plan;
• understanding the covenant visibility that the pension scheme trustees have, and potentially exploring a role for legally enforceable security and the potential economic upside which this might deliver.

It can be compelling for the trustees if the company builds a case that shows its funding proposals not only fit into a sensible long-term strategy but also align with the new funding code.

3. Look at non-cash solutions carefully

Some non-cash solutions have been around for a number of years, but this term now covers a whole range of options, including charges over company assets, inter-company guarantees, letters of credit, escrow accounts and more esoteric options like special purpose vehicles. They can be used to support longer recovery periods and the taking of higher levels of investment risk, whilst also helping to reduce the risk of the scheme generating a surplus that the company cannot get back.

Some companies have rejected the concept of legally enforceable security in the past, for example not being willing to offer a parental guarantee because that is not consistent with corporate policies. However, it is worth investigating the full range of options, especially as some will not have been considered previously.

And, as our recent modelling has shown, the economic value of offering alternative security can be compelling. For many companies this will become even more true as they focus on developing a long term strategy and thinking through the implications of the new funding code.

4. Be clear on the actuarial assumptions that are likely to require most discussion

The actuarial assumptions that we expect will typically require most attention for 2022 valuations are as follows:

• Inflation assumptions – with RPI and CPIH converging from 2030, market-implied RPI appears to be overstated, with investors paying a premium for inflation protection. The level of the CPI wedge and allowance for any inflation risk premium need careful thought for 2022 valuations.
• Life expectancy – the longer term impacts of Covid-19 on longevity remain unclear, meaning the life expectancy assumption needs particular care. However, there is a growing body of opinion that the pandemic will have a negative impact on future mortality improvements. The Regulator has softened its stance in this year’s AFS, by indicating it will accept liability reductions of up to 2% relative to pre-Covid expectations if trustees agree these are appropriate and justified
• Expense reserves – as funding levels improve, it is worth reviewing the funding of expenses. It may be possible to fund expenses out of scheme assets rather than having the company pay them.

5. Get the company governance right

The Pensions Act 2021 creates a raft of new governance challenges for companies, and new, more onerous ‘notifiable events’ reporting requirements are expected to apply to companies from April 2022. Companies should therefore review their pension governance framework. Setting a long-term strategy, considering the role of non-cash solutions, reflecting new notifiable events requirements, working through the use of member options and risk transfer……. these are conversations which are most easily taken forward within an effective governance structure. For more on this, please see our publication on effective corporate governance.

As we emerge from the pandemic, companies with 2022 valuations face both significant challenges and opportunities. As always, the key is early planning and being on the front foot.

To discuss your 2022 funding valuation, please get in touch. 

Blog first published on 30 November 2021.