Dealing with a deficit – failing to plan or planning to fail?

Published by Nick Griggs on

The Pensions Regulator (TPR) has earlier this week published its 2015 funding statement.  The annual statements are aimed at schemes conducting valuations each year, and this statement is intended for schemes with valuation dates between 22 September 2014 and 21 September 2015.

The statement sets out TPR’s analysis of current market conditions and how sponsoring employers and trustees of defined benefit (DB) pension schemes can agree appropriate funding plans which protect members’ benefits without undermining the sustainable growth of the employer.

Schemes face larger deficits

Despite good performance of scheme assets over the period since the previous valuation, and an estimated £44 billion paid to schemes in deficit contributions, many schemes now undertaking a valuation will need to deal with an increased deficit.

Schemes that see only a modest increase in deficit, or where the employer covenant has improved significantly since the previous valuation, may be happy simply extending a current recovery plan or seeking a small increase to contributions.

Some schemes will be in a worse position.  Schemes with a large deficit and/or a weak employer will not be able to take much risk and so TPR expects trustees to seek higher contributions from the employer, with the aim of maintaining the same recovery plan end date, if this is affordable.

Employers may be happy to see TPR say that trustees need to consider the impact of recovery plans on the employer’s sustainable business growth, in line with TPR’s latest objective.  However, with this comes additional scrutiny.  TPR says that if the employer is unable to afford the requested contributions, trustees should undertake increased due diligence.  In particular, if the employer wishes to prioritise investment in the business over deficit contributions, trustees will need to satisfy themselves of how the money will be used and that it will improve the employer’s covenant.  Trustees may also seek additional security to support a longer recovery plan, and may monitor the employer’s activities more closely.

Understanding risks is key

In line with the new Code of Practice on Scheme Funding, TPR is focusing on ensuring schemes manage funding, investment and employer covenant risks in an integrated way.

TPR suggests that some schemes might need to spend more time understanding their risks and putting in place a strategy to assess those risks.  This could include schemes where assets and liabilities do not move together, or mature schemes where if a deficit arises there is less time to make it right.

TPR suggests schemes should also consider the impact of changes in market conditions since the valuation date, so that they can assess whether the assumptions underlying a recovery plan remain appropriate.

Investment returns are a particular source of uncertainty in pension scheme funding.  While some trustees and employers may believe that gilt yields will increase in future to a greater extent than implied by the market, TPR says schemes should be wary of how they make allowance for this in a recovery plan.  Trustees and employers should understand how the scheme’s funding position may change if these expectations are not borne out.  Indeed, some schemes may have made such an allowance at the previous valuation, and the impact of this should be considered.

Importance of contingency planning

With the move to the new Code of Practice, pension scheme valuations are no longer an exercise to be carried out and then filed away for a couple of years.  TPR wants to see all parties to the process getting into the habit of regularly monitoring the scheme’s funding position, and the risks they face.  Good contingency planning can help trustees and employers deal quickly with issues if – or when – they arise.