Trustees are required to set funding assumptions prudently. While there is room for some flexibility in how ‘prudently’ is interpreted, The Pensions Regulator (TPR) highlights in its 2016 funding statement that trustees should be basing assumptions on available evidence.
TPR’s statement emphasises the importance of taking an integrated approach to funding, investment and covenant as set out in their recent IRM guidance. In this blog, the second of a series of three, we consider TPR’s key messages concerning funding.
Allowance for changes to life expectancy
Mortality assumptions should be set in two parts (see TPR’s guidance for example):
- an allowance for how long members are currently expected to live, based on standard tables, a scheme’s own experience or a combination thereof; and
- an allowance for longevity to improve in future, for example due to improvements in lifestyle or medical advances.
A commonly used model for future improvements to longevity is published by the Continuous Mortality Investigation. The latest (2015) version of this model produces slightly lower life expectancies than the 2014 version at some ages. TPR is comfortable with trustees using the 2015 version, as this is based on more up to date data. However, TPR advises that trustees should understand the implications if it transpires this reduction in life expectancies is temporary.
TPR does not believe that there is evidence that this reduction in longevity is the start of a new long-term trend. TPR does not therefore expect trustees to revise their assumption for the long-term rate of improvements under the model as a result of this new data alone.
"Members of DB pension schemes may be considering transferring out of the DB scheme in order to access their pensions flexibly."
Effect of pension freedoms
Whilst pension freedoms arguably do not have a direct effect on them, members of defined benefit (DB) pension schemes may be considering transferring out of the DB scheme in order to access their pensions flexibly. Because of the way the underlying assumptions are derived, transfer values are sometimes lower than the notional funding reserve held in respect of a member, and so more members taking transfer values could lead to an improvement in a scheme’s funding position.
As a result, some trustees may be considering adjusting assumptions to allow for a proportion of members taking transfers from their scheme – for example, where this is an option routinely offered to members approaching retirement. However, TPR believes it is still very much early days for the pension freedoms and there is 'likely to be very little evidence at this time to support adjustments'.
Consider sustainable cost of future benefit accrual
In general, TPR expects schemes to be setting lower assumptions for future investment returns due to recent significant falls in gilt yields. Moreover, if the trustees made an allowance in the previous valuation for gilt yields to increase in future beyond rises already anticipated by markets, TPR expects trustees to reconsider this. In particular, trustees should consider whether to reflect that market expectations are now 'for interest rates to remain lower for longer and to revert to lower long-term levels'.
The fall in expected future investment returns will also lead to an increase in the cost of funding future benefits earned if the scheme remains open to accrual. TPR cautions schemes against using more optimistic assumptions when determining contribution rates, noting that deficit recovery contributions should not be used to subsidise future benefit accrual.
Increased deficits will lead to higher contributions
Our previous blog on TPR’s statement highlighted that many schemes are likely to see an increased deficit at their current valuation. TPR estimates that scheme deficits may be around 20-35% higher than at the previous valuation, although its modelling will not be representative of every scheme.
Estimated impact of market conditions on deficits – December 2012 to December 2015
Sources: The Pensions Regulator, Thomson Reuters, FTSE group, Markit iBoxx
Extensions to recovery plans
Higher deficits are likely to mean that trustees and employers will need to agree changes to existing recovery plans. TPR states that the starting point for trustees’ negotiations should be to maintain the same end date for returning to full funding as under the existing plan.
TPR’s modelling suggests that if schemes choose to maintain existing recovery plan end dates, the median employer would see an increase in deficit recovery contributions (DRCs) of around 75-100%.
Modelled 2016 DRCs as a proportion of DRCs under existing recovery plan based on same RP end date as last valuation:
Source: The Pensions Regulator
Nearly half of employers would need to more than double their contributions in order to keep the same recovery plan end date.
Trustees are able to take some risks in their funding plans, provided that these are appropriate. TPR expects trustees to make sure they understand the risks they are taking and to monitor these risks. At each valuation, the trustees should consider the impact of risk scenarios on the sponsor as part of their funding considerations. Increased employer contributions may well be required at a time when the employer is least able to handle such an increase. TPR asks trustees to set contingency plans in case they need to adjust the scheme’s risk exposure in future.
For many schemes – in particular those with a valuation date in the latter part of the tranche covered by TPR’s current statement (for example, between late June and September 2016) – the impact of the EU Referendum result (‘Brexit’) on financial markets could have a significant knock-on effect on funding assessments.
TPR’s statement was issued before the referendum result was known with a promise that 'it will also consider whether a further statement … is necessary following the results of the EU referendum'. Earlier this week, TPR issued that further guidance in which it advises trustees “to remain vigilant and review their circumstances, but continue to take a considered approach to action with a focus on the longer term”. The Regulator recognises that it is 'too early to understand or assess the full consequences of the outcome of the EU referendum in detail'. Nevertheless, trustees should have “open and collaborative” discussions with employers about the impact on their business. TPR also emphasises that “trustees and sponsors should speak to their advisers if they are concerned or need help in understanding the risks”.
Pensions Minister Baroness Altmann had also noted there is 'a case for considering how pension liabilities are valued for regulatory purposes' and was understood to be keeping an eye on the impact of economic stimuli designed to ease the financial shock of Brexit.
In our final blog on TPR’s funding statement, we will take a more detailed look at the follow-up ‘Brexit’ statement, as well as considering what the Regulator has to say about the affordability of employer contributions and how trustees may mitigate the additional risk arising from changes to a recovery plan.
Atia Iram contributed to the writing of this blog post.