Pensions Regulator publishes annual funding statement

The Pensions Regulator (the Regulator) issued its 2020 annual funding statement yesterday (30 April).

While the funding statement will be of particular relevance for defined benefit pension schemes with valuation dates between 22 September 2019 and 21 September 2020 (Tranche 15 Schemes), certain principles set out in the funding statement will also be of general application for other defined benefit schemes.

The funding statement acknowledges that many sponsoring employers of defined benefit schemes are likely to be going through very challenging times as they deal with the effects of the COVID-19 pandemic on their businesses. In this context, trustees and scheme sponsors are encouraged to work collaboratively in order to manage the immediate impact of the pandemic. The Regulator also emphasises the importance of retaining a focus on the longer-term and will consider issuing further guidance in the autumn as the impact of the pandemic evolves over time.

Funding positions

The Regulator expects the funding position of Tranche 15 Schemes to vary depending on the exact valuation date.

While there was a general improvement in funding positions as at 31 December 2019, a small proportion of Tranche 15 Schemes with valuation dates in the first quarter of 2020 (particularly those that had not de-risked and had high exposure to equities) are likely to have experienced a sharp fall in funding levels.

In particular, the Regulator notes the following:

• The Regulator does not expect Tranche 15 Schemes that are close to finalising their valuations to revisit their agreed valuation assumptions to reflect post-valuation experience. However, having regard to possible COVID-19 impacts on their sponsors’ businesses, trustees of such schemes may consider sponsor affordability aspects when setting recovery plans.

• Tranche 15 Scheme that are in the earlier stages of the valuation process should consider taking account of post-valuation experience.

• Trustees are asked to exercise caution in addressing requests by sponsors to bring forward their valuation dates (more likely to be the case for Tranche 15 Schemes with valuation dates around 31 March 2020). The Regulator expects to question trustees on the reasoning for any such change to valuation dates.

• It would be reasonable for trustees of Tranche 15 Schemes with March and April 2020 valuation dates to want to delay taking decisions on actuarial assumptions until a reliable view can be arrived on the long-term future returns on scheme investments.

Recovery plans and affordability

The funding statement emphasises the importance of trustees having an appropriate understanding of the sponsor covenant (see below) and the need for trustees and sponsors to act collaboratively in finalising scheme valuations. In the current COVID-19 impacted environment, in addition to appropriate core deficit reduction contributions (DRCs), trustees are encouraged to consider:

• incorporating appropriate incremental increases in contributions which track corporate health recovery (especially where the scheme takes on additional funding risks in supporting the sponsor’s recovery through the pandemic); and

• basing additional contribution requirements on appropriate triggers such as free cash flows, investment performance and payments to other creditors.

Reiterating previous guidance issued in March 2020, trustees are asked to be open to sponsor requests to reduce or suspend DRCs in line with the following principles:

• the need for the proposed action is justified;

• a plan is made for any deferred scheme payments to be caught up;

• where appropriate, a plan is agreed for mitigating any detriment caused to the scheme; and

• the scheme is being treated fairly compared with other stakeholders.

Trustees are also encouraged to have a long-term funding target for their scheme consistent with how the trustees and the sponsor expect to deliver scheme benefits in the long-term.

Having such a long-term strategy is expected to become a legal requirement when the Pension Schemes Bill 2020 is enacted. The new funding code for defined benefit schemes (currently under consultation until September 2020) will also address the long-term funding target requirements. However, the new funding code is now not expected to come into force until late-2021 at the earliest.

Covenant assessments

The Regulator acknowledges that COVID-19 has resulted in uncertainty over some sponsors’ covenant strength and their ability to address funding deficits in the short term. In these circumstances, the Regulator expects the frequency and intensity of covenant monitoring to be “significantly increased” until covenant visibility and strength is restored.

Trustees are encouraged to:

• identify key aspects of the sponsor covenant to track and decide when action is required based on appropriate triggers or thresholds, informed by the level of change that could have a material impact on the sponsor covenant and therefore the scheme’s funding or investment strategy;

• put in place contingency plans (ideally with input from the sponsor) with agreed trigger points that will result in specific actions being taken (as an example, additional DRCs of a set amount being paid into the scheme if the funding level deteriorates below an agreed level); and

• be vigilant of unjustified sponsor covenant leakage (e.g. through dividends, cash pooling and inter-company lending, transfer of business assets at an undervalue, group trading arrangements or excessive executive remuneration) and, where appropriate, seek suitable protections to compensate the scheme for any resulting deterioration of covenant.

Integrated risk management

There is a continuing expectation that trustees would focus on the integrated management of the three broad areas of risks faced by schemes – the sponsor covenant, investment risks and the scheme’s funding plans.

As with the Regulator’s previous annual funding statement issued in 2019, the current funding statement includes tables setting out the Regulator’s expectations in relation to schemes which have been segmented based on key drivers such as funding strength, sponsor covenant and scheme maturity. While the tables are not intended to be exhaustive, they provide a helpful reference points for trustees and sponsors on the Regulator’s ongoing expectations in connection with scheme funding.