Funding in a cold economic climate? TPR’s first annual statement

Introduction

TPR has today published the first in what is to be a series of annual statements on scheme funding. Aimed at providing guidance for trustees of DB schemes who are going through the valuation process, the statement sets out TPR’s views of “acceptable approaches” to scheme funding in the current economic climate.

In this Alert:

• Key points
• Climate change: Riding the economic waves
• Risk management: An integrated approach
• Calculating the technical provisions
• Recovery plans
• A lighthouse in the economic storms?

Key points

• While TPR’s statement is particularly aimed at trustees and employers who are undertaking valuations with effective dates between September 2011 and September 20121, it is relevant to all trustees and employers with a DB pension scheme.2
• TPR reminds trustees that a scheme’s funding strategy “must be tailored to its own specific circumstances”.
• Although not every point made in the guidance will apply equally to all schemes, the statements are “consistent with the universally applicable principles which underlie the funding framework”.3
• Emphasising that “there is sufficient flexibility within the funding framework” to address current market volatility and the resulting challenges this brings, TPR expects that the majority of schemes and employers “will be able to manage their deficits within current plans”.

Climate change: Riding the economic waves

Since the beginning of the current economic crisis, TPR has sought to guide trustees through the funding turbulence4, setting out its expectations for protecting members’ benefits “without undermining the viability of employers, whose support is vital to pension schemes”. Factors such as low gilt yields and quantitative easing continue to put pressure on pension scheme funding.

Recognising the impact of market volatility, TPR notes that schemes with effective valuation dates in December 2011 may appear less well funded than those with effective dates in March 2012, following a general improvement in conditions in the first quarter of 2012. However, TPR is keen to point out that existing flexibility in the funding regime means “that the outcome should not necessarily be more burdensome for those employers”. It is also of the view that a substantial proportion of schemes will be “broadly on track to achieve previously agreed plans” as a result of existing risk management, asset allocation and contribution strategies.

Risk management: An integrated approachTPR expects trustees to adopt an “integrated approach” to scheme funding, bringing together information and advice on investment, the employer covenant and actuarial factors “to inform a complete financial management plan”. In particular, trustees should:

• document their considerations, so that they can explain their funding decisions based on the advice received in relation to the different strands of the process;
• undertake contingency planning, to ensure that they have “viable alternative options” in the event that assumptions made are not borne out in practice. TPR expects the level of detail “should be proportionate to the risk being taken”; and
• not use an earlier effective date in order to take advantage of more favourable economic circumstances to reduce deficit contributions. Account may, however, be taken of “actual post valuation experience”, where appropriate.

Calculating the technical provisions

Trustees must ensure that their scheme is funded using prudent assumptions, based on the strength of the employer covenant. Key factors to be taken into account when calculating a scheme’s technical provisions include:

• measurement of investment outperformance on the basis of a “near-risk free return” (such as would be assumed if a scheme adopted a substantially hedged investment strategy);
• consistency of asset and liability measures – smoothing of the discount rate is not considered to be consistent with the requirement to value assets on a mark-to-market basis; and
• no “second guessing” of market movements, for example by assuming that gilt yields will inevitably improve in the short-term. TPR recommends that any strongly held views about future financial market conditions should be accommodated in the recovery plan, rather than the technical provisions, so they can be more easily identified and mitigated if found to be inaccurate.

Recovery plans

Unsurprisingly, TPR considers that recovery plans should “usually be based on what is reasonably affordable without compromising the employer’s long-term ability to support the scheme”. In doing so, trustees should ensure that:

• the current level of deficit repair contributions should usually be maintained in real terms;
• there is documented justification for any reduction in deficit contributions (for example, where there has been a “demonstrable change in the employer’s ability to meet them”);
• the scheme is “treated equitably” among the competing demands on the employer; and
• sound justification can be provided in the event of a material extension to the recovery plan. However, TPR is aware that certain employers will “find affordability a challenge” and may need to increase the existing length of their recovery plan significantly.

TPR notes that while most employers can afford appropriate dividend payments without prejudicing scheme funding, such payments may need to be reassessed if there is a “substantial risk” to the provision of benefits promised under the scheme.

A lighthouse in the economic storms?

TPR has provided this statement in anticipation that it will help trustees and employers to reach “acceptable” funding agreements. While it expects that, in most cases, regulatory involvement will not be needed, TPR will be on the lookout for any schemes which take an approach to scheme funding which is not in line with the statement.

1 The statement does not specifically address valuations relating to dates earlier in 2011 when “conditions were materially different”
2 See TPR’s press release
3 For more information, please see our brochure:”The funding cycle – the four key stages”
4Previous statements were issued by TPR in June 2009, February 2009, October 2008