The recent financial market volatility and rapid increase in the cost-of-living have created a lot of work in recent weeks for many, including pension scheme trustees and sponsors.
There is a great deal to consider, and ensuring that all relevant matters are addressed is a challenge. To assist with this, we draw together the key issues that schemes should be considering in the present economic environment.
DB scheme funding: consider the scheme’s funding and risk position
As the Regulator notes in its 12 October 2022 statement on managing investment and liquidity risk in the current economic climate (the Statement), it will be “useful for all schemes to review their current funding positions in light of market changes”. Although the impact of recent events will vary depending upon specific circumstances, most DB schemes will have seen an increase in funding levels because of higher long-term gilt yields.
A review may include the potential impact of future yield movements, whether funding improvements can be locked in with some schemes perhaps being able to consider moving to buy-out and whether the funding strategy and risk profile remain appropriate.
General: understand the current position including hedging, liquidity, risk profile and contingency plans
Trustees should liaise with investment advisers to understand the current position of the scheme. This will include consideration of:
- liability hedging levels, which the Statement notes, is an issue facing all schemes not just those that use liability driven investment (LDI);
- liquidity arrangements including: (a) whether there is adequate liquidity to satisfy future collateral calls in unstable conditions; (b) the ‘liquidity waterfall’ – the order in which liquid assets will be realised, if need be, to meet collateral calls; and (c) cash management and disinvestment plans;
- the balance of risk in the investment portfolio and whether the risk profile needs rebalancing; and
- contingency plans.
LDI: review the LDI strategy
Recent market events have had a particular impact on those schemes that use LDI. Schemes with a LDI investment strategy will need to consider if and how the strategy needs to be adapted for the future. Although the impact on schemes will vary, considerations will include matters such as:
- management of future collateral call and liquidity requirements;
- how the strategy has performed under recent stresses and whether it is meeting its objectives;
- in schemes that are now less well hedged against future drops in bond yields, whether to continue with reduced hedging levels or whether to maintain previous levels and how to do this; and
- in schemes that had previously chosen not to hedge, whether higher Government bond yields mean it is now desirable to implement some hedging.
Employer funding: requests for employer funding
Schemes that have not been able to meet additional collateral calls because of liquidity issues may wish to ask the employer for accelerated future contributions or to otherwise provide liquidity, for example, to provide a loan to the scheme.
Borrowing from the employer may only be done if the scheme rules permit this (and conditions may apply), to provide liquidity for a scheme and on a temporary basis. There are limits on the amount that can be borrowed and certain other HMRC/ Finance Act 2004 restrictions. It is essential that trustees take legal and financial advice if they plan to borrow from the sponsoring employer.
DC schemes: review investment strategy
Trustees should review their investment strategy remembering to keep a long-term view of investment performance. A clear understanding of members’ retirement behaviour and chosen means of accessing their funds will be needed to review whether the ‘at retirement’ phase of the strategy performed as expected during recent volatility.
Employer covenant: consider the impact on the employer’s business
Schemes should consider the effect of the present economic climate on the employer’s covenant. High inflation can increase costs for employers whilst at the same time they may see demand fall. Higher interest rates are also likely to increase borrowing costs. Trustees will wish to understand the effect, if any, on the sponsoring employer’s business.
DB schemes: consider discretionary increases
Many members will see a ‘real term’ reduction in benefits because salary increases, deferred revaluation and pension increases are unlikely to keep up with inflation.
Therefore, some trustees and employers will wish to consider (if they have not already done so) whether the scheme’s governing provisions allow benefit increases to be augmented and if they do, whether to use this discretionary power. Relevant factors must be taken into consideration when deciding whether to augment benefits – these include factors such as the purpose, scope and terms of the power, scheme funding, member benefit security and whether additional funding is needed to meet the cost of any augmentation.
DC schemes: consider effect on fund performance and decumulation
Trustees should consider issues such as the effect on fund performance and how members in decumulation may be impacted.
The impact on DC members will largely depend on: (1) the effect that recent events are having on the value of funds particularly those invested in gilts which will have decreased in value as yields have increased, and (2) how close members are to taking their benefits (typically the closer a member is to retirement the larger the proportion of gilts held, hence there may be a larger adverse impact on fund value). Conversely, annuity rates have improved due to the increase in gilt yields which will benefit those members buying an annuity.
Pension scams: be vigilant
Trustees should also remain alert to pension scams and adhere to good practice – as noted by the Regulator, market uncertainty increases opportunities for scammers.
Early retirement and transfer values: consider factors and assumptions
Schemes will also need to consider whether the factors and assumptions underlying early retirement and transfer value calculations remain appropriate.
As regards early retirement, trustees need to make sure that they are meeting statutory preservation obligations concerning the value of ‘short service’ benefits, that is ensuring that early retirement benefits are broadly equivalent in value to those that would otherwise be payable at normal retirement date.
Member communications: consider existing and specific communications
Trustees will need to assess whether existing member communications need amending and whether specific communication needs to be made to members informing them about the situation and relevant action that the trustees may be taking.
In respect of DC schemes, the Regulator has specifically referred to:
- communicating with members approaching retirement to inform them about options and referencing the importance of financial advice; and
- encouraging savers that may be making decisions about their benefits to either obtain financial advice or contact MoneyHelper.
Operational matters: make sure existing processes and procedures are sufficiently robust
As the Statement notes, schemes need to make sure that their processes and procedures are sufficiently robust to allow them to respond to developments as and when they arise. This includes liquidity and cash management – investment transactions and decisions may need to be made at short notice.
The Regulator says that schemes should consider whether appointing a professional trustee may assist in this regard.
The key ‘take away’ message from the above is that, if they have not done so already, trustees should liaise with their advisers as soon as they can to ensure that they are addressing all relevant matters in light of current economic conditions and taking the right steps for their scheme.
Further background information on recent market events including the Statement can be found in the insights produced by our colleagues in the Gateley Legal pensions team which can be accessed here and here.