The Pension Regulator’s (tPR’s) annual statement - which acts as a guide to the trustees and employers of Defined Benefit (DB) pension schemes, particularly those whose triennial valuations fall this year – has underlined the importance of DB schemes understanding and managing cashflow risk for the first time. It also highlights the need for trustees to have a clear understanding of covenant risk, the importance of which has been underlined by several high profile schemes being assessed for entry into the pensions lifeboat in recent weeks.

Explaining why it’s vital to look at scheme cashflows, Jon Hatchett, Partner at Hymans Robertson, said:

“DB schemes are exposed to considerable risk if they don’t understand their cashflow requirements. Our research last year found that UK DB schemes are paying out around £20bn more p.a. than they receive in contributions – in other words, overall they are cashflow negative. This situation will worsen now schemes are closed, with net outflows rising to around £100bn in 15 years’ time*.

“Yet only 4% of trustees focus on the risks of being cashflow negative. This is despite the fact that the majority of schemes already are, or soon will be in this situation as they become increasingly mature**. Levels or awareness are almost 10 times as high amongst independent trustees***.  This underscores the need to raise awareness of this risk more broadly.

“It’s great to see tPR bringing this issue to the fore. The risk of being a forced seller of assets is largely a new one for DB schemes, but will continue to grow in scale.  It’s essential to look at the cashflows generated by scheme assets and the extent to which they could meet liabilities. It’s an approach we have advocated for some time and it’s reassuring that it is beginning to gain traction in the wider market. The issue will be better managed as a consequence.”

Discussing the importance of having a clear understanding of covenant risk, he added:

“Only through having a clear understanding of covenant risk is it possible to truly understand the chance of pensions being paid. Events of recent weeks have underlined the importance of having a strong sponsor. If the pension becomes too big a burden for the company and it fails, pensioners will lose out to the tune of £45,000 on average if they have to be caught by the pensions lifeboat, the PPF.

“Companies have paid £500bn into pension schemes since 2000, yet the combined deficit facing UK plc has tripled to £800bn. In the last year alone we’ve seen companies commit over £30bn of cash largely in an attempt to repair deficits, yet we are no further forward. Just asking sponsors for more cash isn’t going to solve the problem. There’s a pressing need for a different approach to managing scheme funding risks.

“The Pensions Regulator has effectively said that where sponsors can pay more, they should do so. Whilst this may sway popular opinion in light of the events at BHS, it won’t be right for everyone.  The focus on cash contributions has distracted too many from the greater challenge of managing the risks in pension scheme funding.  Even if cash contributions were to magically double, they would still be dwarfed by the volatility of UK plc’s pension balance sheet.  What we should be focussing on is ensuring contributions that are adequate in the circumstances and stable for the employer.  This stability will provide management time and space for the challenging job of managing the risks in DB funding.”

Providing a steer on what schemes should do to become more resilient to risk, he said:

“Our clients have weathered the financial storms of the last few years well.  They’ve become more resilient to risk by doing three things: having a clear purpose, proceeding at a controlled pace, and making more precise decisions.  Expanding on these three points further:

• By putting in place clear measurable objectives to drive strategy, clients are able to make clearer, more coherent and quicker decisions.
• There’s no urgency to be fully funded, as schemes will be paying pensions for many decades to come. Making a conscious decision not to try and get to the end point as quickly as possible is one of the simplest ways to reduce risks and save money in the bad times.  In our experience, when clients measurably incorporate long term covenant risk it often offers further evidence in favour of proceeding at a steady pace.  It emphasises the pension security and cash stability benefits of giving assets more time, taking less risk and making longer term cash commitments.  This is a surprising rarity in UK DB despite persistent calls for integrated risk management.
• Finally, for too long, schemes have been relying on member data that is up to three years out of date.  This is a crazy state of affairs in the 21st Century, especially with the flux caused by the pension freedoms.  Schemes can get valuations that are bang up to date at no extra cost, and when they do it’s possible to make better decisions and take advantage of opportunities to de-risk.”

Agreeing with tPR that schemes should not revise life expectancy assumptions downwards, he concluded:

“tPR is right to warn trustees against unthinkingly adopting CMI 2015, or indeed any other longevity model. The early months of 2015 saw high numbers of deaths compared to previous years, driven by a virulent strain of flu, which that winter's flu jab failed to protect against. This may have skewed the data. If schemes adopt this model it may underestimate current levels of mortality improvement. Or perhaps we really have reached a turning point of slower and more volatile improvements in life expectancy.” 

“This clearly highlights yet again that longevity risk can bite.  Trustees and sponsors should ensure they are accessing analysis and tools to intelligently measure risk and consider the market price of removing it.  Recent market innovation opens up longevity hedging to a much wider range of schemes than was historically the case.”