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The Pensions Regulator publishes 2023 Annual Funding Statement

By Graham McLean and Adam Boyes | April 27, 2023

The Pensions Regulator has published its 2023 annual funding statement, which is relevant to trustees and sponsors of all private sector defined benefit pension schemes.
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On 27 April 2023, The Pensions Regulator (TPR) published its latest annual funding statement, which is relevant to trustees and sponsors of all private sector defined benefit (DB) pension schemes. It applies particularly to those undertaking an actuarial valuation with an effective date between 22 September 2022 and 21 September 2023 (referred to as ‘Tranche 18’ valuations) or undertaking reviews of funding and risk strategies. TPR also notes the relevance of the statement to schemes that may be receiving requests for reduced contributions, amendments to contingent asset arrangements, or proposals for using surplus.

The statement includes a reminder that the current funding regime applies until all the new legislation and the revised DB funding code come into force. TPR’s corporate plan published last week signalled that it is now expecting to bring the new code into effect in April 2024, and this is repeated in the statement.

TPR also notes that its guidance on assessing, and monitoring sponsor covenants will be updated later this year, providing more detail on covenant visibility, reliability, and longevity (which are key aspects of covenant in the draft DB funding code published last year) as well as how to treat guarantees for scheme funding purposes. It will also provide more information regarding environmental, social and governance (ESG) risks and how these can be factored into the covenant.

Context for the statement

TPR notes that the significant rise in gilt yields and favourable returns on return-seeking assets will mean many schemes’ funding positions will be well ahead of plan, with a significant number now exceeding buyout funding and only a minority seeing recent funding position deteriorations. TPR also notes that the value of the assets and liabilities of many schemes will now be much smaller than at the time of the previous valuation, meaning that sponsor covenants may now appear proportionately stronger, particularly so for contingent assets expressed in fixed monetary amounts. Schemes are urged to review long-term objectives and funding and investment strategies that were set when interest rates were low and TPR encourages schemes to do this in the light of changes in circumstances, taking into account funding, investment and covenant.

Despite the improvement in funding levels for many schemes, the statement pushes trustees to recognise the economic uncertainty that could continue to affect schemes and sponsors, including further interest rate rises, high rates of inflation and geopolitical instability.

For those schemes that remain open to accrual, the rise in interest rates will have led to a reduction in the expected cost of future benefit accrual and, where they are immature, they may also have experienced significant increases in funding levels giving rise to a wide choice of future strategies.

Funding considerations

If funding levels have improved significantly, trustees should consider whether continuing with the existing strategy is in the best interests of members, or whether using some of the funding gains to finance de-risking is more appropriate.

TPR notes that schemes in this position may also be facing calls from employers to reduce or suspend contributions as well as calls from members for discretionary pension increases where scheme pensions have not been fully indexed in line with inflation.

In the minority of cases where funding levels have fallen, TPR believes that funding and investment strategies should be reset in order to reach long-term targets, with operational processes reviewed to ensure future resilience (including the matters set out in TPR’s liability driven investment (LDI) guidance issued on 24 April 2023).

The statement provides specific guidance on the funding considerations for ‘re-thinking strategies’ across three groups of schemes depending on how well funded they are relative to buyout (‘solvency’) and technical provisions measures:

Group I: Where funding level is at or above buyout

TPR estimates that one quarter of schemes could now be in this position. Trustees should consider whether proceeding with a buyout is the best way to lock in any funding gains, or whether running on the scheme may be a better option for members, as it offers them potential to benefit from future surpluses. Employers may prefer to have an ongoing arrangement that allocates some surplus to fund scheme expenses, future accruals or to benefit members in a DC section. Considerations for running on include the future use of any surplus versus the risks involved and how these can be mitigated. TPR stresses the importance of taking advice on these issues, considering the scheme’s rules and the trustees’ duties.

Where buyout is the preferred route, schemes should prepare thoroughly to put themselves in the best possible position both on the data and benefits side as well as with the assets, recognising that the overall process can be a lengthy one.

Group II: Where funding level is above technical provisions but below buy-out

Schemes should consider whether their long-term objective remains appropriate (and where a long-term objective and target hasn’t been established then it should be done as a priority). Schemes should also review their plans for transitioning their investment strategy over time to align with the long-term objective and consider setting triggers for further action, for example if the funding level improves significantly.

TPR suggests that it would be good practice to consider the steps that can be taken now to align with the key principles in the draft funding code, particularly in relation to low dependency funding targets, investment allocations and funding basis.

Group III: Where funding level is below technical provisions

The focus for these schemes should be on eliminating the funding deficit as soon as the employer can reasonably afford. Technical provisions should be revisited to ensure that they are consistent with the scheme’s long-term funding target, with risk-taking supported by the covenant and reducing over time

If the funding position has deteriorated over the past year the trustees should understand the reasons for this and re-build their funding and investment strategy reflecting the changed circumstances.

TPR notes that its guidance from previous years still applies and is repeated in the tables accompanying the statement.

Investment considerations

The asset allocation for many schemes may have changed materially as a result of the rise in interest rates in 2022. Schemes should consider the implications for their investment strategy including the split between matching and growth assets, the need for future investment returns and the amount of leverage in LDI (referring to TPR’s latest guidance), taking into account the funding position and the scheme’s objectives.

Trustees should seek advice on managing illiquid assets where these represent a greater proportion of the scheme’s total assets than originally envisaged, and TPR outlines a range of factors to take into consideration.

Covenant considerations

While there may appear to be less reliance on covenant if the funding position has improved, TPR stresses the importance of understanding the impact of different economic scenarios on the scheme and how these could increase the dependency on the sponsor.

Trustees should also not overlook the short-term impact of the current economic environment on the covenant, including the effects of higher interest rates and energy costs, ensuring that they understand the key factors affecting the employer’s resilience.

TPR warns against complacency when monitoring covenant, reminding trustees of the importance of obtaining financial projections and business plans while also ensuring they adhere to information sharing protocols. It recognises that some Trustees may consider it appropriate to amend the scope of their covenant assessment to focus more on covenant longevity and ESG issues.

Those schemes with a sponsor experiencing corporate distress or acute affordability restrictions should refer to TPR’s additional guidance.

Other considerations

The statement acknowledges that mortality rates in 2022 were higher than pre-COVID levels but notes the uncertainty over the future outlook and the need for care in interpreting past trends. TPR expects many trustees will revise their mortality assumptions after taking advice from the scheme actuary and reiterates that any changes should be appropriate and justifiable. However, unlike last year’s statement, no guidance is given on the magnitude of the changes in liability values that TPR is expecting for current valuations.

TPR’s views on the challenges posed by high inflation and the planned changes to RPI from 2030 onwards remain unchanged from those set out in last year’s AFS.

If a scheme is ahead of plan and considering whether to reduce or stop deficit contributions, trustees should:

  • For weak or weakened covenants: consider whether the technical provisions are sufficiently prudent and whether the level of investment risk is still supported
  • Where the scheme has a technical provisions (TP) deficit: consider reducing the remaining length of the recovery plan and any allowance for investment outperformance before reducing the level of contributions.

If shareholder distributions exceed contributions or if covenant leakage is material, TPR considers that it is unlikely to be appropriate to reduce deficit recovery contributions (DRCs) while the scheme has a TP deficit.

Where a scheme agrees to stop or reduce DRCs outside of a formal valuation, TPR encourages the trustees to put in place a mechanism to recommence contributions if funding gains reverse.

If employers seek to renegotiate the terms of any contingent assets, TPR expects trustees to evaluate proposals critically and to understand the value being given up against a range of reasonable scenarios. If any changes are made trustees should consider how to make provision for the arrangements to be revised upwards if the funding position later deteriorates.

Contacts

Graham McLean
Head of Scheme Funding
email Email

Adam Boyes
Head of Trustee Consulting
email Email

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