The Pension Regulator publishes its Annual Funding Statement 2021
The Pensions Regulator’s Annual Funding Statement 2021 includes a number of key messages for relevant schemes including in respect of covenant, COVID-19, Brexit and mortality assumptions.
The Pensions Regulator (the Regulator) has published its Annual Funding Statement 2021 (the AFS) for trustees of defined benefit (DB) schemes. The AFS is primarily aimed at schemes with valuation dates between 22 September 2020 and 21 September 2021 (Tranche 16) and those schemes experiencing significant changes that require a funding and risk strategy review. It also has general relevance for other schemes.
Unsurprisingly, COVID-19, Brexit, and the endgame for schemes feature heavily. The ongoing importance of covenant and monitoring is confirmed. The Regulator emphasises that although short-term visibility of covenant may have improved, trustees must remain vigilant to risks from weakening of the covenant given the ongoing uncertainties, climate change and longevity experience.
The AFS also provides an update on the timing of the revised DB funding code – it is expected that the second consultation will take place towards the end of 2021 with the code now not expected to come into force until late 2022 at the earliest.
A summary of the key points of the AFS
1.1 Group tables:
As with previous statements, group tables set out the Regulator’s expectations based on employer strength, funding levels and maturity. These are consistent with last year’s statement and identify the key risks trustees are expected to concentrate on and expected funding plan features.
The AFS provides guidance for trustees on how they should consider long-term funding and investment depending upon the effect of COVID-19, Brexit, scheme maturity and funding position compared to the scheme's long-term objective.
1.3 Tranche 16 funding levels:
In the three years to March 2021, aggregate funding levels for Tranche 16 schemes on a technical provisions basis did improve although the position will vary significantly for individual schemes compared with Regulator estimates.
1.4 Long-term funding targets:
Schemes are encouraged to set a long-term funding target with a plan as to how to reach that goal if they have not already put one in place, taking into account the forthcoming statutory requirements to set a long-term strategy which are contained in the Pension Schemes Act 2021. Schemes which already have such a strategy should find that they can continue with this with 'suitable short-term modifications'.
1.5 Actuarial assumptions and scheme demographics: emphasis on inflation and mortality assumptions
Inflation reform: The intended alignment of the RPI with CPIH from 2030 means that inflation assumptions will need to be carefully considered both before and after 2030
Mortality: The Regulator understands that the short-term mortality effect of the pandemic for most schemes is relatively low although this will depend upon scheme circumstances. The different opinions as regards the long-term future impact are noted alongside a recognition that it may take some time before the actual position is known.
Potential reasonable approaches that schemes may wish to take are discussed; for example, keeping the mortality assumption similar to other valuations and recognising savings in future valuations should evidence for changed assumptions arise or using the latest base mortality tables and projections, adjusted for scheme experience where appropriate and with consideration of the weighting given to recent events in these models.
Overall, the approach should be balanced, supported by evidence, and use a 'sound methodology' with justification for amendments and contingency plans should assumptions be significantly weakened, and the position not end up as anticipated.
Post valuation experience: trustees can take into account post valuation experience. However, this needs to account for both negative and positive matters. It is not to be used to "pick the most favourable date for agreeing the recovery plan". If positive post valuation experience has been allowed for previously, 'material negative' post valuation changes must be taken into account. Favourable post valuation events should normally reduce recovery plan length not the annual payment amount.
Because most schemes are closed to new members, liquidity risks must be actively monitored and mitigated. Reference to what the analysis should include is outlined in the AFS.
1.7 Covenant considerations
Assessments of covenant: Consideration of obtaining independent specialist advice is emphasised especially in certain situations including where the covenant is complex or deteriorating, the COVID-19 recovery outlook is not clear or where the scheme has a high degree of reliance on the covenant.
COVID-19: Coming out of the pandemic, it is anticipated that employers will fall into three main groups: (1) COVID-19 has had a limited impact on the business (Group 1); (2) it has had a material initial impact but there has been a strong recovery (Group 2); or (3) it has a continuing material effect (Group 3).
Trustees should consider stress testing or scenario planning which 'reflects possible future economic environments', especially trustees in Group 3 who should also consider if there has been a material deterioration in covenant.
Brexit: The AFS sets out what actions should be taken by trustees where employer covenant uncertainty has been increased by the UK's withdrawal from the EU. This includes a review of employer covenant, an assessment of the effect on the employer's position and considering how any investment in the employer will be funded.
Sponsoring employer in distress: Trustees should ensure that they are familiar with the Regulator's protecting schemes from sponsoring employer distress guidance – the Regulator will liaise with those schemes in respect of which there are corporate distress concerns to make sure that this guidance is being followed.
1.8 Affordability and deficit repair contributions (DRCs):
Group 1 – A business as usual approach should be adopted for setting recovery plans where external developments such as COVID-19 and Brexit have had a 'limited impact'. Consequently, DRCs are not generally expected to be reduced or recovery plan periods lengthened;
Group 2 – A short term reduction: for Group 2, any requests for reduced contributions are expected to be 'short term, with higher contributions in subsequent years limiting any extension to recovery plan end dates; and
Continued requests for DRC deferrals/lower ongoing DRCs should be paired with suitable mitigation.
1.9 Covenant monitoring and contingency plans:
The increase in covenant monitoring which has generally taken place is welcomed and continuation is encouraged as 'good practice'. This should be accompanied by contingency plans produced together with the employer if possible and documented accordingly. Covenant leakage should be on trustees' radars and if unjustified needs to be met with suitable protection for the scheme.
1.10 Expectation of increased corporate activity:
As the pandemic recovery continues there is an expectation of increased corporate activity and trustees need to be prepared, take a 'rigorous approach' to consideration of the impact and negotiation of mitigation and keep appropriate records. Should the activity coincide with the valuation this can be used as leverage, but mitigation should be obtained separate to the valuation.
1.11 Climate change:
The Regulator sees proactivity in this area as integral to 'successful saver outcomes' and trustees need to be are aware of its climate change strategy (see our Insight Update).
1.12 Scheme maturity:
Maturity issues will become more significant in relation to funding and investment for schemes which are closed to new members and the associated risks must be appropriately managed.
This year's AFS has a clear focus on covenant and sets out its expectations for relevant schemes as we enter what is hopefully the start of a recovery phase in the pandemic. Trustees and employers should ensure that they are able to justify and explain their approach with relevant supporting evidence.
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