Finance Directors' Guide to Pensions
Actuarial valuations are required by law for all occupational defined benefit pension schemes and are used to determine whether the scheme has sufficient assets to meet the anticipated future benefit payments due from the scheme. If there is a shortfall then a recovery plan will be agreed between the employer and the trustees to rectify it.
They are carried out under the Scheme Funding regime, as set out in the Pensions Act 2004. These regulations came into force on 30 December 2005 and replaced the old Minimum Funding Requirement regime.
Schemes' actuarial valuations are carried out at least every three years and are the responsibility of the scheme's trustees, although the employer should engage in the process at an early stage. The trustees and employer have 15 months to complete the valuation, which involves the following:
and actuarial assumptions, including discount rates, must be chosen prudently
in the method or assumptions used at the next valuation must be justified by legal, demographic or economic circumstances
and other demographic assumptions must be based on prudent principles
The process of agreeing the assumptions, and the nature and length of a recovery plan, will involve negotiations between the scheme sponsor(s) and the trustees.
The balance of power between the Trustees, the Employer and potentially the Scheme Actuary in determining the assumptions will depend on the scheme's Trust Deed and Rules. Only very rarely do trustees have all the power to determine the assumptions. The Trustees are advised on the valuation process by the Scheme Actuary and sponsors are increasingly seeking their own independent advice.
Employers will find that taking a proactive lead is helpful in negotiating a favourable result. The trustees may require thorough justification in order to accept alternative assumptions so the sponsor should be prepared to provide this. With Trustees placing great importance on the strength of the sponsor's covenant when determining the level of prudence to include in the assumptions the employer should engage with the trustees in this process.
"It is essential that employers take the initiative and get involved in the valuation process at an early stage."
The Pensions Regulator (TPR) has published a code of practice on scheme funding, which provides practical guidelines on legislative requirements. The Code is addressed to trustees of defined benefit occupational schemes, but TPR acknowledges that it will also be used by employers.
The code is based around nine key principles, as follows:
Collaboration between trustees and employer
Integrated risk management covering covenant, investment, and funding risks with triggers for action in each area
Taking risks only up to a level where the employer can mitigate adverse outcomes over a reasonable period
Taking a long-term view
Taking an approach that is proportionate to the size, complexity, and circumstances of the scheme
Balancing trustee duties against the need for a healthy sponsoring employer
Fair treatment of the scheme against other calls on the employer's resources
Any shortfall against funding targets should be eliminated taking into account both the scheme's and the employer's circumstances
The single most important factor, when considering an appropriate amount of prudence to be included within the calculation of the technical provisions, is the sponsor covenant. That is, the sponsor's legal obligations to the pension scheme and its ability to meet them.
The trustees' assessment of the covenant will depend on the likelihood, willingness and legal obligation of the sponsor to meet its obligations to the pension scheme. It will be assessed by looking at areas such as, the company's business model, its current balance sheet strength and profitability and its future projections, its prospects within the market place and the ranking of the pension scheme relative to other creditors.
In theory, the greater the covenant afforded to the scheme, the less prudence that is required. This is because the trustees should be more comfortable that the scheme can endure adverse market conditions as the sponsor can afford to fund any shortfall. At the other extreme, where the sponsor covenant is virtually non-existent and the employer is close to going insolvent, the scheme's funding objective may be more closely linked to a buy-out approach. That is the level at which the trustees could discharge their liabilities and the full benefits could be secured with an insurance company.
Trustees of pension schemes can often underestimate the covenant afforded to their scheme and as such, incorporate undue margins of prudence in their actuarial assumptions. This can lead to larger cash contributions than strictly necessary being called for from the sponsor. When undertaking covenant assessments, TPR asks trustees to work collaboratively with the employer.
Sponsors should also be aware of the balance sheet implications of overly prudent funding and unrecognisable surpluses; this is discussed in more detail in the Accounting section.
TPR's defined benefit regulatory strategy outlines its approach to regulating the statutory funding objective. The key parts are:
1. Assessing the risk levels of each scheme - TPR will use risk indicators such as:
the employer covenant and the risk of employer support being withdrawn, reduced or unavailable
The trustees’ and employers’ funding plan
whether the investment risk taken by the scheme is appropriate to the covenant strength
the level of governance in the scheme.
2. Prioritising interventions using a 'risk tolerance threshold', considering:
the nature of the risks posed;
the potential impact of engagement; and
TPR's available resources at the time.
TPR does not expect to engage directly with many smaller schemes, but may undertake specific campaigns directed towards smaller schemes to ensure the intended messages get through.
3. Methods of intervention
TPR will be clear and open about the issues it wishes to investigate and will aim to give guidance on a range of acceptable solutions, rather than prescribing any particular outcome.
The key financial assumptions that are used to measure a scheme's technical provisions, and should be agreed between the sponsor and the trustees, include:
Discount rate (both pre and post retirement);
Pension increases in payment;
Revaluation in deferment; and
The pension increase and revaluation assumptions are driven by assumptions on future inflation. The inflation assumption is also used to determine the increases on inflation linked benefits. It is usual for this to be derived from market indices although an adjustment is often made to the market implied breakeven inflation figure.
The choice of discount rate usually has the greatest impact on the value placed on the liabilities, so it is important for the employer to understand the approach being taken.
The key demographic assumptions include:
Current and future mortality;
Cash commutation; and
The longevity assumption is probably the most significant of the demographic assumptions. With rapid (and expensive) improvements in life expectancy seen in recent years, and current life expectancy now above 88 for an average 65 year old male, there is much debate on whether these will persist in the future.
The other demographic assumptions such as the allowance for cash commutation and the proportions married should not be ignored as they can have a reasonably significant impact on the results.
Where sponsors are looking to negotiate with trustees they should consider undertaking an investigation into the scheme's actual experience as these can often be sufficient to provide trustees with the comfort that is required to alter an assumption.
Where the actuarial valuation reveals a deficit (i.e. the technical provisions are greater than the scheme assets), an appropriate recovery plan must be put in place. This sets out how the deficit will be repaired over a pre-defined period. While trustees will seek to remove the deficit as quickly as possible, they should not be looking to push an otherwise viable sponsor into insolvency. TPR has made it clear that recovery plans should be “appropriately tailored to the scheme’s and employer’s circumstances”.
Temporary short term factors should be separated from long term outlooks when determining what is reasonably affordable for the recovery plan as a whole, although where there are short-term concerns over affordability a longer recovery plan or back-end loading may be appropriate to ensure the long term heath of the sponsor.
It is becoming increasingly common for sponsors to offer alternative forms of security to allow an extended or back-end loaded Recovery Plan to be agreed with the trustees. These can include parent guarantees, charges over company assets or other business backed guarantees.
It has also become increasingly common to include an allowance for higher investment returns to be earned during the period of the Recovery Plan which reduce the contributions payable by the employer. This is most common where particularly prudent assumptions have been used to determine the technical provisions.
This training video gives Companies sponsoring defined benefit pension schemes a brief outline of the Actuarial Valuation process, details of what to expect from trustees and how best to manage the process.
Our work involved providing support to a multinational company which acquired a UK operation with a large (>£3bn) DB scheme several years ago through a historic transaction.
We provided support to the company in its negotiations with the trustees during the triennial valuation process.
This involved keeping the management team, based in Europe, up to date with developments in UK pensions, analysing and challenging assumptions and figures prepared by the scheme actuary, exploring alternative scenarios with the company and preparing a counter-proposal and support during meetings with a trustee sub-committee.
As part of the analysis we were able to demonstrate that, under the trustees’ proposed funding plan, the scheme could potentially be fully funded on a buy-out basis ahead of the end of the proposed recovery period. As part of the counter-proposal to the trustees we helped develop a framework which could be used to manage the funding level of the scheme towards a buy-out position over a longer time horizon. One of the conclusions reached was that it would be more efficient to target a buy-out once the majority of deferred members have retired, to avoid having to purchase deferred annuities which tend to be much more expensive compared to immediate annuities.
We also worked closely with our investment team, who are also advising the company, in developing the counter-proposal. They used cashflows provided by the scheme actuary to prepare an analysis of the progression of the funding level over time which the company was able to use as part of the counter-proposal. The investment team also carried out an analysis for the company to give them a better understanding of the interest rate, inflation and credit risks inherent in the trustees’ investment strategy which highlighted potential areas where further de-risking could be considered.
The negotiations were challenging as our analysis provided good evidence for the company to pay reduced contributions. The strategy adopted by the scheme had served it well over the three years to the valuation date and the position had improved. The trustees were reluctant to accept a reduction to the current level of contributions and the matter was further complicated because the scheme actuary has a role in setting the contribution rate.
The end result was that although the company was unable to secure an extension to the recovery period it was able to negotiate down the deficit and secure a significant reduction in total contributions. The company was also able to secure a cap on future contribution requirements should the deficit increase at the next valuation (which is effectively an undertaking to extend the recovery period in the event of adverse experience).
The Pensions Regulator (TPR) has published regulatory guidance for trustees and employers, intended to help develop an Integrated Risk Management (IRM) approach to scheme funding.
Employers and trustees will already be familiar with the three key financial risks to pension schemes which TPR expects to drive scheme funding decisions. However, this new guidance is intended to help trustees model, understand and mitigate the ways in which funding, investment and covenant risks interact.
TPR says 'IRM is an important tool for managing the risks associated with scheme funding'. In particular, IRM focuses on the interaction between risks in three key areas:
This guidance sets out the ways in which trustees can work with their advisers and sponsoring employers to build an effective risk management structure. It also considers what IRM will look like in practice, and explores some examples of risk assessment approaches.
TPR expects trustees to adopt a long-term proportionate approach, noting that 'there is no one set formula for what IRM should look like'. Trustees are expected to work together with the employer in developing their IRM, and should take account of the ‘risk appetites’ of all parties involved.
TPR recommends a multistage approach:
TPR’s guidance also considers some of the tools trustees might use to develop an IRM framework, including:
Such modelling can also provide valuable input to the employer’s own risk management.