Finance Directors' Guide to Pensions
As the scheme matures outflows will exceed inflows and the fund assets will need to be called upon to meet these payments. There are two sources of money to pay benefits; contributions paid to the scheme and investment returns on invested assets. Effective investment of the fund is paramount to meet these later requirements to the extent that if investment returns are insufficient, additional contributions will be required.
The trustees of the scheme are responsible for the fund and their ultimate aim will be to manage the fund in such a way to ensure that all members' benefits, throughout the lifetime of the scheme, are secured and paid in line with the members' expectations and any legislative limits.
In most cases, the trustees will outsource the day-to-day investment decisions and the running of the fund to their appointed investment managers but remain responsible for the higher level investment decisions. Most of these decisions are set out in the Statement of Investment Principles (SIP) which all but the smallest schemes are required to have and review at least every three years. Trustees are likely to receive advice on their investment strategy from an investment consultant.
Although employer agreement is generally not required for trustees to make investment decisions there is a formal requirement to 'consult' the employer before signing the SIP; some schemes' rules may require greater employer input. It can therefore be beneficial to both parties for the employer to be involved at all stages and take advice on these matters.
Involvement on an ongoing basis of the company in investment matters will improve communications and build relationship for future requirements. This may include company and adviser attending investment meetings.
The employer's overall objectives for the pension scheme are central to any investment review. If the trustees have different ongoing objectives for the scheme than the employer, there will be a different approach to setting the investment and funding strategy. This discrepancy should be minimised in order to run the scheme effectively.
The investment strategy should be appropriate to meet the long term objectives. If the level of investment risk is increased to meet these objectives then the employer has the possibility that he may need to increase contributions if the financial markets do not play in his favour in order to meet objective on time. There is an inherent trade off between the level of risk that can be taken and the level of contributions required from the employer.
A scheme's investment strategy is the key driver of the ultimate cost of the scheme to its sponsor. It is the trustees who have the ultimate responsibility for setting the strategy but the employer should recognise that it has an important role to play and should maintain an active interest.
Trustees must decide on and implement an appropriate investment strategy. The employer may have different objectives from the trustees when considering investment strategy. For example, the employer may be concerned about volatility on its balance sheet, or the profit and loss charge, whereas the trustees are likely to prioritise security of benefits. By engaging with the trustees an employer can at least get these alternative objectives recognised. Often trustees will be willing to invest in a particular way as a condition of receiving additional or accelerated funding or some other form of enhanced security.
The success of the trustees' chosen investment strategy ultimately impacts the employer financially. It is vital the employer understand the strategy options and the related impact on future costs and associated risk. With a suitable, up to date, advantageous investment strategy, contributions can be used effectively to improve the funding position.
There is a direct relationship between the funding assumptions chosen and the level of contributions paid by the company. Small changes in the assumptions chosen by trustees can have a large impact on a scheme's valuation and thereby the financial implication for the employer. It is important the employer understands the rationale and margins of prudence before accepting the assumptions chosen.
For the majority of schemes the assumptions underlying the technical provisions and recovery plan need to be agreed with the employer. The wide range of assumptions available can produce very different contribution requirements. The valuation year is an important time to assess the sensitivity of the scheme's liabilities, and therefore the employer's contributions, to these.
For schemes in deficit, there are a variety of options when structuring a Recovery Plan to clear the deficit. The Regulator has stated that, in some cases, it may be appropriate for longer recover periods, "back-end loaded" contribution rates, and/or less prudent assumptions. These can all help reduce employers' short-term cashflow commitments.
With objectives agreed for the pension scheme and the investment strategy set accordingly, it is important that the assumptions are also congruent. There should be a consistency between the term of the objectives and the assumptions set in order to meet them.
Pension scheme trustees and sponsors are increasingly looking towards managing funding volatility and transitioning to a lower risk investment strategy as their scheme matures. However, many schemes are still funded on actuarial assumptions which imply that significant investment risk will continue to be taken over the future lifetime of the scheme. It is necessary to consider appropriate methods so as to react to opportunities to reduce investment risk as they arise.
After objectives are set this gives an indication of the expected future funding position. When the actual funding position is ahead of this path, having triggers in place to realise the gains will enable the scheme to 'bank' this unexpected investment performance and use this to mitigate some of the risk of the deficit increasing in future.