The Pensions Regulator’s Annual Funding Statement 2022 the (AFS) contains a number of key messages for relevant schemes many of which follow on from recent years’ statements.
These are delivered against the backdrop of current economic uncertainty which unsurprisingly also forms a central part of the statement. Our In-depth Insight covers the main points below.
The AFS focusses on schemes that are undertaking valuations between 22 September 2021 and 21 September 2022 (Tranche 17) or undergoing material changes that necessitate a review of their funding and integrated risk management. It also has general relevance for other schemes.
In general, the AFS continues messaging from earlier statements with an emphasis on integrated risk management, consideration of the scheme's long term funding target (LTFT) and maintaining communication with the employer. It highlights the importance of robust risk management for pension schemes undergoing valuations in challenging conditions including high inflation, higher interest rates and slower economic growth.
Tranche 17 funding levels
The Regulator’s analysis has indicated that the aggregate funding level for all Tranche 17 schemes is ahead of what had been expected three years ago. David Fairs, the Regulator’s executive director of regulatory policy, commented that “favourable investment conditions over the last three years mean that many schemes’ funding levels are ahead of plan, but now is not the time for complacency”.
Considerations for current valuations
The present economic uncertainty could affect schemes currently undertaking valuations in various ways including:
Inflation: high inflation rates having the potential to increase employer costs and materially increase scheme liabilities or affect investment asset values;
Energy costs: higher energy costs will particularly affect employers heavily reliant on energy;
Interest rates: further interest rate rises could increase employer borrowing costs and impact a scheme's assets and liabilities;
Ukraine conflict: for most schemes, Russia/Ukraine linked investments will make up a minor element of the scheme's investments. However, the conflict has caused uncertainty generally and both direct and indirect impacts from a wider economic perspective (see here for the Regulator's guidance on the Russia/Ukraine situation);
COVID-19 & Brexit: may still be impacting some employers.
Covenant, recovery plans and affordability
The AFS asks trustees to consider the impact that market events may have on a sponsoring employer’s business and categorise it in one of three ways:
||Recovery plan & affordability: trustees should consider the following
|Category one - current market events which have had a limited impact on business, with no balance sheet weakening and a strong cash flow remaining.
||Trustees should have a 'business as usual' approach to recovery plans where market conditions have had a limited effect on the employer's business with an expectation that deficit recovery contributions (DRCs) are not reduced, or recovery plans extended
|Category two - current market events which have had a significant impact, although trading has recovered or is largely recovering, or the impact is expected to be short-term.
||Trustees should 'carefully consider' any requests to temporarily reduce contributions where employers have short-term affordability issues. Requests should be short term and there should be higher contributions in following years with recovery plan end date extensions limited.
|Category three - current market events which continue to have a material impact where the rate of recovery is not known, or the business may never completely rebound.
||Adequate mitigation should be provided where employers request DRC referrals and/or lower ongoing DRCs
Trustees should consider obtaining specialist covenant advice particularly if the covenant is complex or is weakening or has been materially impacted by current market events as set out under category three above.
Shareholder distributions and other forms of covenant leakage
The Regulator notes an increase in shareholder distributions. Trustees should be alert to these and look at whether the scheme is being treated fairly in comparison to other stakeholders – the Regulator's expectations on fair treatment remain the same as those set out in its 2019 annual funding statement. Trustees should also be aware of other types of covenant leakage.
Corporate activity levels are high and trustees should be ready to take swift action with a robust assessment of the impact on the scheme and appropriate record-keeping. Trustees should note the Regulator's recently updated clearance guidance in this regard which contains statements on different forms of mitigation and its appropriateness.
Actuarial and investment considerations
Interest Rates – as long-term interest rates have risen and gilt yields remain unstable because of market conditions, the Regulator has asked trustees to consider the investment and funding strategies as well as the level of hedging in place.
Inflation – the Regulator has used its AFS to recommend that trustees carefully consider the methods used when applying recent and short-term inflation rates to valuation calculations. The Regulator has asserted the importance of considering how interest rates and inflation changes will impact a LTFT.
Mortality – as with last year’s statement, the Regulator has considered the impact of the pandemic on mortality rates. It has added that any reduction in liabilities caused by changes in mortality assumptions should be no more than 2% unless it is supported by strong evidence.
The AFS reminds trustees that although not yet implemented, the Pension Schemes Act 2021 will make it a legal requirement for schemes to set a long-term strategy which works towards a long-term objective, and that trustees should take steps now to adopt a LTFT. The Regulator has asked trustees to be mindful of long-term reliance on the employer covenant up to and beyond the LTFT, ensuring that journey plans remain appropriate and that they focus upon the relevant risks.
Schemes are expected to remain focussed upon managing risks through integrated risk management and suitable contingency planning. As the present economic situation means that funding and covenant could alter very quickly trustees should have in place suitable regular monitoring and contingency plans. Contingency plans should include alternative funding and investment strategies which place less reliance on a sponsoring employer where there are concerns regarding covenant long term as well as suitable funding and risk triggers for those schemes with a funding surplus (schemes in surplus being a newly included section of the statement).
As with previous annual funding statements, group tables set out the Regulator’s expectations based on scheme and employer characteristics; employer strength, funding levels and maturity. Whilst these tables are largely consistent with last year’s statement and identify the key risks trustees are expected to concentrate on, the reference to the length of recovery plan has changed from ‘shorter than seven years’ to ‘six years’ in order to reflect a reduction in the average recovery plan length over recent years.
Update on DB funding code and covenant guidance
The AFS also provides an update on the timing of the revised DB funding code which is expected "later in 2022" thus allowing time to "learn from the DWP's consultation on the draft regulations".
The Regulator will also release details of its suggested amendments to its employer covenant guidance and other related guidance and provide more information on the treatment of guarantees in respect of scheme funding and on ESG and covenant.
To conclude, it is clear that covenant exposure to market conditions is a key concern for the Regulator. Aside from this the themes remain consistent with those from recent years with an emphasis on the importance of integrated risk management and having a long-term journey plan.