UK: Regulator Predicts Doom And Gloom

Last Updated: 22 June 2015
Article by Alison Hills

Deficits are on the way back up again; and risk management, employer covenant strength and investment strategy are once again thrown into sharp focus for pension scheme trustees...

Last month the Regulator issued its third annual Funding Statement and a separate evidence and analysis document.  The Funding Statement is accompanied by two reports which provide analysis on: (i) the position based on schemes with effective valuation dates between 22 September 2012 and 21 September 2013; and (ii) the position that the Regulator expects to see in relation to schemes with valuation dates between 22 September 2014 and 21 September 2015.

The headline message isn't great: "for many schemes, liabilities have grown faster than assets since their Tranche 7 valuation, resulting in increased deficits".  This has happened despite most asset classes performing well in the period, and can generally be attributed to record low consumer price inflation, gilt yields and interest rates.  This won't come as news to many of us in the industry, but how are schemes dealing with these increased deficits?

What does the Funding Statement say?

The Regulator analysed how schemes had tried to address these unwelcome deficit increases:

  • Discount rate outperformance: the Regulator notes that critical factors when setting a scheme's discount rate areinvestment risk and employer covenant.
  • Increase in recovery plan period: over half of the employers facing an increase in deficit decided to extend their recover plan end date, the average extension being three years.
  • Increase in deficit recovery contributions: out of the schemes analysed, 66% increased their average annual deficit recovery contributions with two-thirds of those schemes increasing their deficit recovery contributions by more than 25%.  The Regulator notes that the employer covenant and affordability are important considerations when agreeing appropriate levels of deficit recovery contributions.  However, its analysis shows that out of the schemes analysed, on average the increase in deficit recovery contributions didn't appear to be impacted by the strength of the employer covenant.

It isn't all doom and gloom though, as the position for a handful of schemes seems to be improving:

  • 25% of schemes which carried out a valuation in 2013 and 2014 increased their discount rate performance and a further 25% maintained their outperformance;
  • around 15% of schemes have brought forward their recovery plan end date; and
  • 34% of schemes did not increase their deficit recovery contributions.

What does the evidence and analysis report say?

The Regulator recognises that many schemes will seek to manage increased deficits through a combination of increased deficit recovery contributions and extending the recovery plan.  The Regulator notes that many employers appear to be able to afford higher deficit recovery contributions.  The employers of those schemes are likely to look to the Regulator's updated Funding Code for support as it encourages an integrated approach, where contributions, investment risk (including the employer's attitude to it), affordability and the risk to members are all taken into account   Equally, the Regulator acknowledges that where affordability is more constrained, the trustees and employer will have to work hard to agree an appropriate solution. 

The Regulator re-enforces the message, in this report, that recovery plans can be tailored to the circumstances of the scheme and employer but how it remains important that deficits are recovered over an appropriate period of time.  Elsewhere in the report is a prediction that 17% of schemes may need to extend their recovery plan periods by at least twelve years in order to extinguish their increased deficits, based on maintaining deficit recovery contributions at their current level.

Wedlake Bell comment

All in all, however, it isn't great news: deficits have grown due to circumstances outside the control of trustees (and, indeed, outside the control of many sponsoring employers too).  It is vital that trustees continue to instruct seek advice to help them to satisfy their duties in managing these deficits.  Professional advisers will also be able to assist trustees in contingency planning, something which the Regulator promotes in this statement.  Where extra cash is unavailable trustees should consider seeking contingent assets, an area where the industry has become particularly creative over recent years.

The Regulator ends its statement with a promise to provide further practical guidance on adopting an integrated approach to managing risk, covenant assessment and setting investment strategy.  This is intended to be complementary to the Funding Code.  Hopefully this will be helpful to trustees, but it certainly won't be a miracle cure!

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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