Hot topic: Annual funding statement 2020 – what employers need to know

Introduction

TPR’s annual funding statement (published on 30 April 2020) acknowledges that these are very challenging times for many businesses (see our Alert). Employers will be relieved to see an emphasis on trustees and employers working together to manage the impact of COVID-19, with a focus on affordability for sponsors. However, TPR does not expect this to be at the expense of pension scheme security, with the statement continuing the drive towards all DB schemes having a long-term funding target (“LTFT”). Employers should therefore expect extra scrutiny from trustees, in particular on the strength of the employer covenant and the risks of covenant leakage.

The statement is particularly relevant to schemes with valuation dates between 22 September 2019 and 21 September 2020 (“Tranche 15”), as well as schemes undergoing “significant changes that require a review of their funding and risk strategies”.

Key points for employers

COVID-19 impact on current valuations

• Schemes close to completing their valuations are not required to revisit their assumptions, even though they will have been set under very different conditions than those prevailing now. However, TPR does expect post-valuation experience to be considered in recovery plans, along with extra due diligence on the employer covenant. Recovery plans should balance affordability and the sustainable growth of the employer with fair treatment of the scheme.
• Employers are likely to see trustees requesting incremental increases in contributions which track the recovery in corporate health. TPR expects this especially where a scheme has taken on additional funding risk while supporting the employer’s recovery. TPR recommends that additional contributions should be based on appropriate triggers, such as free cash flow and payments to other creditors. Employers should prepare for this to be a hot topic for negotiation.
• Additional contributions could also be linked to investment performance. Where optimistic returns are assumed in the recovery plan (when compared with the scheme’s technical provisions), TPR warns trustees to be mindful of the consequences for member security of such optimism not being borne out in practice. If appropriate, trustees should consider seeking contingent arrangements (for example, extra contributions or security) to take effect if investment performance is not achieved.
• TPR advises caution on moving valuation dates – for example, moving the date back from 31 March 2020 to 31 December 2019, when conditions were considered more normal. TPR expects trustees to take legal and actuarial advice, and to consider very carefully whether this is in the best interests of members. Trustees who take this decision can expect TPR “to question their reasons for the change”.

A closer eye on covenant

Employers should anticipate extra scrutiny of their covenant for the near future. TPR expects the frequency and intensity of covenant monitoring to be “significantly increased” in light of COVID-19 and Brexit, until covenant visibility and strength is restored. Employers should be asked by trustees to discuss key risks and to develop contingency plans, and TPR may ask trustees for evidence of these discussions.

Employers should also assume that trustees will be alive to potential covenant leakage. Echoing its previous COVID-19 guidance (on DB scheme funding and investment), TPR expects pension schemes to be treated equitably compared with other stakeholders. This isn’t just aimed at shareholder distributions; trustees are also asked to be “vigilant” of other potential forms of covenant leakage, such as inter-company lending, group trading arrangements, or excessive executive remuneration. Employers might be asked by trustees for more information on these arrangements.

Finally, TPR once again shows its preference for trustees to take independent specialist covenant advice, warning that trustees deciding to “do-it-themselves” should lay a full audit trail of their considerations and decisions, which TPR may then ask them to share. Some employers may therefore find themselves being asked to engage with independent covenant advisers for the first time.

Managing risks

Following the approach of previous years, TPR segments schemes based on their risk profile (funding strength, covenant and maturity), dividing schemes into 10 categories. The tables are the same as those introduced in the 2019 funding statement, and set out the key risks and actions for trustees and employers to focus on, depending on the scheme’s category. The impact of COVID-19 and Brexit on the covenant, and how good the funding position is relative to the LTFT, should be considered to decide which category now best reflects the scheme’s situation.

Next steps

TPR will risk assess valuation submissions it receives “in a proportionate way”, but employers and trustees should be “fully prepared to justify and explain their approach with supporting evidence”.

As the “duration and impact of the current economic uncertainty evolves”, TPR will consider issuing further funding guidance in the autumn.