The Pensions Regulator’s annual statement on funding agreements, published today, suggests that trustees should start by asking whether the current level of contributions can be maintained, warns against “overly prudent” approaches to managing risk, and sets out the choices that schemes have under the legislation. Towers Watson says that, in many cases, the statement may bring the Regulator’s formal expectations into line with what schemes were doing anyway.
In general, employers and pension scheme trustees must negotiate new funding agreements knowing that deficits have got bigger. In analysis published alongside today’s statement, the Regulator suggests that half of schemes with actuarial valuations in 2013 could expect to stay in deficit for at least an extra five years if nothing else changed and that more than one in ten could anticipate needing an extra twenty years of deficit contributions.
Graham McLean, senior consultant at Towers Watson, said: “Even though employers have been paying record contributions, deficits have been growing. For many schemes, funding agreements based on market conditions in late March or early April will be their toughest yet. More schemes are looking at solutions such as asset-backed contributions but for most the choice will involve some combination of the employer paying more now or seeing the date when it can expect to stop paying contributions pushed back.”
Higher contributions, longer recovery periods or a bit of both?
The Regulator’s statement says that ‘as a starting point, trustees should consider whether the current level of contributions can be maintained’.
Graham McLean said: “Some employers are expecting to stump up more cash and can afford to, but the question has always been how much is reasonable. The Regulator suggests that if contributions damage future plans that grow the covenant to the scheme they would be too much, too soon. That is the basis that most trustees were working on anyway. As a result, it will not be uncommon for the date by which the trustees can expect the scheme to be fully funded to have to be at least as elastic as how much the employer pays up front. The Regulator has again announced that it will no longer automatically scrutinise all recovery plans longer than 10 years - it might find itself somewhat stretched if it tried to.”
What is excessive prudence?
Michael O’Higgins, the Regulator’s chairman, has said that mitigating risks does not require [trustees] to be overly prudent.
Graham McLean said: “This is a good headline, but it’s not clear whether the Regulator is just knocking down straw men. It has given no examples of things it has seen trustees do that it regards as excessively prudent, let alone said that it will start to challenge valuation agreements on these grounds. We’ll have to see whether this leads to any change in behaviour on the ground.
“This change in tone may make trustees think the Regulator is less likely to back them if push comes to shove and may embolden employers to stand their ground. However, schemes already knew that the Regulator had yet to wield its power to impose funding settlements and would only seriously consider using it as a last resort. Trustees and employers generally do not wait to be told what to do by the Regulator, and nor should they: its generalised statements cannot capture all of the nuances of their situation and those involved with individual schemes have to make judgements themselves. Most just get on with it.”
Setting the discount rate and making assumptions about future gilt yields
This year’s annual statement reminds trustees that discount rates can be set taking account of expected returns on the scheme’s assets as well as or instead of the yields on government bonds. It includes a helpful reminder that ‘assumptions made for the relative returns of different asset classes may rise or fall from preceding valuations reflecting changes in market conditions and the outlook for future returns’.
Graham McLean said: “Most schemes already allow for better returns than they would anticipate if they simply invested all of their assets in government bonds. The dispute was not about whether discount rates can be higher than gilt yields; it was about how to set them.
“There has never been any requirement to assume that returns from assets such as equities or property will exceed gilt yields by the same amount regardless of market conditions. The Regulator has not exactly gone out of its way to advertise this in the past and it’s encouraging if this is starting to change. However, properly-advised trustees should have known what their options were without needing the authorities to tell them.
“The centrepiece of last year’s statement was a song and dance about the perils of assuming that gilt yields would rebound to a greater extent than the market implies. That has neither been reiterated nor formally recanted. One reason for this not being repeated may be that deficits are now bigger. Last year’s statement said that ‘by exception’, schemes may need to make assumptions about yield reversion in order to avoid carrying out major surgery on their recovery plans. This will be less exceptional today but it’s not clear why need ever came into it. For schemes that plan to buy gilts in future, the price they can expect to pay is just one of many things they will need to make judgements about and is not obviously deserving of special regulatory attention.
“Today’s output feels a little different from the regulator’s previous comments. For example, its analysis illustrates how a higher discount rate can mitigate the impact on recovery plans, which is not the sort of idea it would previously have wanted to put into anyone’s mind.”
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