Paul Kitson, UK Head of Pensions Consulting at EY, comments: “Today’s Annual Funding Statement (AFS) reflects the profound shift we have seen in the funding of UK defined benefit (DB) pension plans over the last year. The Pensions Regulator (TPR) estimates that a quarter (25%) of UK DB pension plans – around £400bn – are now at or above funding levels to buy out.
While better funding is positive news for corporate sponsors and scheme members, it will challenge pension schemes to secure a buy out, given demand will significantly out-weigh provider supply.
“Despite buy out providers working hard to increase their volumes and new entrants coming to market, we expect a significant bottle neck for some time to come. Companies and trustees looking to buy out need to take action to stand out in a crowded market. As firms navigate this shift in funding positions, it is pleasing to see TPR highlight the importance of advice to manage illiquid assets and getting buy out ready, and indeed to consider alternatives to buy out.
“Overall, there is merit in trustees and corporates ‘thinking like an insurer’. This will lock in current funding levels, both for those in a holding pattern for buy out and to help with longer term run-off for those looking for a different way forward.”
Jane Evans, Partner at EY Parthenon, comments: “The changes in pensions funding since last year – at a time when many corporates are facing turbulence as a result of high interest rates, refinancing risks and higher costs – means reviews of scheme strategies are now essential, rather than a nice to have.
“But even with many pension schemes being better funded than they have been historically, today’s Annual Funding Statement (AFS) emphasises the importance of trustees maintaining a close focus on sponsor covenant. This is key because with demand outstripping supply in the buy out market, even a well-funded scheme may need to rely on its sponsor for some time. However, the scope of covenant work needs to keep pace with the changing scheme needs and not fall back on what might have been helpful last year. In this volatile market, the position can change rapidly, and scenario planning can help trustees respond quickly to protect members’ benefits should the need arise.
“TPR’s delay of the DB funding code is a fair decision in light of the changing market, however, it means that companies and trustees face ongoing uncertainty about what the requirements will be. This means trustees and companies alike should already be thinking about what might be coming to avoid uncomfortable cliff edges.”
John Dunn, Head of Pensions Funding and Transformation at PwC UK, says:
“As an indicator of just how much the pensions world has changed over the last 12 months, for the first time, this year’s annual funding statement includes guidance to trustees and sponsors of pension schemes that expect to have at least enough assets to transfer the pension scheme to an insurance company.
“Since the last annual funding statement long-term interest rates have doubled which means that schemes are now operating in a very different economic environment. Across all 5,000-plus UK defined benefit pension schemes combined the impact of rising interest rates has been positive but, as TPR highlights, the picture on a scheme by scheme basis is quite varied. We are pleased to see that TPR is encouraging all scheme trustees and sponsors to re-think their funding and investment strategies. As a result, we are likely to see many schemes being able to simplify their strategies, reduce costs and focus on assets that will deliver reliable cash flows to pay members’ benefits.
Katie Lightstone, Partner in Employer Covenant and Restructuring at PwC UK, says: “The Pensions Regulator (TPR) has acknowledged for the first time that there is a range of endgame strategies and not all schemes are on a one-way train to buyout.
Running on a scheme rather than buying out could be in members’ and corporates’ best interests, for example, where they could both benefit from potential future surpluses. We’re seeing an increasing number of clients considering the value for both trustees and employers at the heart of well-funded schemes.
“This will lead to further innovation in the market, with a focus on covenant scenarios and contingency plans to ensure members are no worse off than if a buyout had been pursued. It will be fundamental for trustees and corporates to fully assess their options to choose the best route for members.
“In all scenarios, a good understanding of employer covenant will be central to decision making. TPR has reminded trustees that the scheme and sponsoring employer are intrinsically linked until the scheme’s endgame has been achieved - even where a buyout is pursued this could be several years.
“As funding positions improve, the covenant focus is likely to shift to align with schemes’ potential revised strategies. This could mean a need for trustees to switch focus from free cash flow to the key risks to the covenant, such as climate risks or the economic outlook.”
ACA Chair, Steven Taylor, Comments: “After significant recent improvements to funding levels, today’s statement strikes a markedly different tone to previous Annual Funding Statements. TPR notes that for around a quarter of schemes that are already fully funded to buy-out levels, the end-game is now here and the next set of challenges for schemes could involve answering questions around use of surplus and acknowledging some of the practical challenges of navigating through busy buy-out markets.
“”For other schemes that remain below, but are now far closer, to buy-out levels than previously expected, the statement offers fresh challenge to trustees to revisit strategies to make sure they remain sufficiently ambitious, whilst acknowledging the continued need to manage ever present downside and upside risks such as around inflation and life expectancies.
“For sponsors, there are potentially mixed emotions here. With much of the hard work now seemingly done, many will have been hoping to negotiate some respite from onerous recent funding requirements. Today’s statement may encourage trustees to continue to drive hard bargains and so sets the stage for some potentially intense strategy discussions over the coming year.”
Tyron Potts, Associate and Head of Pensions Research at BW, said: “TPR recognises the economic landscape is very different to this time last year - and for most schemes, the result is positive news. However, it is clear TPR retains a little nervousness particularly around sponsor covenants and, as a result, is urging trustees to ensure that they use their improved funding positions to reduce risk in the scheme rather than necessarily allowing the sponsor to benefit. Trustees are also warned not to overlook the impact of short-term economic volatility on sponsors’ trading prospects.
“But this should not come as a surprise to trustees, as TPR isn’t really adding a lot here to what has already been said – particularly as part of its Code of Practice consultation. Nevertheless, if we read between the lines, there are a few nuggets of additional information that can be gleaned.
“In particular, in explicitly acknowledging that some schemes which are fully-funded on a buy-out basis might decide they are better off running-on with an appropriate risk buffer (rather than buying out now), TPR has now opened the door for up to one-in-four sets of trustees and employers to re-visit previous discussions around their end-game strategies.
“And while TPR is openly encouraging schemes to de-risk if their funding level has improved, in spite of its warnings of potentially limited capacity in the buyout market, the Regulator rightly suggests that well-funded schemes nevertheless ensure they are “buy-out ready”. Being in a position to transact quickly will give a scheme a much-needed competitive advantage when a short-lived window of capacity opens up with an insurer – and so using advisers’ knowledge of the buy-out market will now become even more important.”
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