UK: Annual Funding Statement 2023: Trustees Urged To Lock In Funding Gains And Review Long Term Targets

Overall, the Regulator's Annual Funding Statement strikes a positive tone with most defined benefit schemes experiencing improved funding levels through a combination of investment out-performance from return-seeking assets and a significant rise in gilt yields. Around a quarter of schemes are expected to be funded above buy-out; with many others exceeding their technical provisions.

However, the Regulator warns against complacency, urging trustees that have seen funding levels improve to:

• consider steps they might take to lock-in the funding gains;
• review their long-term targets and end game options; and
• remain vigilant when monitoring their employer covenant.

A minority of schemes might have experienced a reduction in funding levels over the past year or more. Where this is so, trustees may need to reset their funding and investment strategy to ensure they remain on track to reach their long-term targets.

All schemes are reminded of the need to review their operational and investment governance processes to ensure future resilience, in line with the Regulator's updated LDI guidance.

Background

The Annual Funding Statement is for trustees and sponsoring employers of occupational defined benefit (DB) pension schemes. It sets out specific guidance on valuations under current conditions, particularly for schemes with valuation dates between 22 September 2022 and 21 September 2023 (Tranche 18), as well as schemes undergoing significant changes that require a review of their funding and risk strategies. It also includes content relevant to schemes that receive requests to:

• reduce deficit recovery contributions;
• amend contingent asset arrangements; or
• use a surplus in the scheme in some other way.

The current funding regime applies to Tranche 18 schemes, with the new statutory funding requirements and revised DB funding Code not now due to come into force until April 2024 at the earliest.

Although most Tranche 18 schemes are likely to have seen an improvement in their funding position since their last valuation, this will not be universal. In any event, trustees are reminded of the need to ensure their funding and investment strategy remains appropriate and to remain vigilant to potential deterioration in their employer covenant and to ongoing economic risks.

Economic risks

While trustees of most schemes are likely to be approaching valuations from a relatively healthy funding position, the Regulator reminds them of the need to recognise the economic uncertainty that may continue to impact investments and employer covenant in different ways, including:

• further increases in interest rates, which could affect the scheme's assets and liabilities, as well as increasing borrowing costs for employers, potentially making refinancing more difficult;
• high rates of inflation and their knock-on effects on pension scheme liabilities and investment returns, as well as their effect on other employer costs (such as raw materials and operating costs), which they may not be able to pass onto customers;
• volatile commodity and energy prices affecting profitability of employers and fueling inflation in the wider economy; and
• the potential for ongoing or new geopolitical instability and/or conflict to affect supply and distribution chains or cost bases of employers.

Funding positions

The Regulator expects that:

• around a quarter of all DB schemes may now have sufficient assets to buy-out their liabilities with an insurance company;
• the majority of other schemes are estimated to have funding positions that are currently ahead of their funding plans, and in many cases ahead of their technical provisions; and
• the funding levels for a minority of schemes are likely to have fallen.

Unsurprisingly, the guidance varies depending on which category a scheme falls into.

Funding level at buy-out or above

Where a scheme is funded above buy-out level, trustees should consider their options and the timing of any potential buy-out (where this is their preferred end game option). Trustees are reminded of the need to take action to put their scheme in the best possible position to approach what is likely to be an increasingly competitive buy-out market.

Given that it can take several years to prepare for and execute a buy-out, the Regulator also stresses the need for trustees to ensure their favourable funding position remains resilient to future market movements and that their scheme's dependency on the employer remains minimised.

Funding level above technical provisions but below buy-out

Where a scheme's funding position exceeds its technical provisions but is below buy-out levels, trustees are expected to:

• consider whether the scheme's long-term objective and timescale for reaching it remains appropriate;
• consider the need to strengthen their scheme's technical provisions; and
• review the suitability of their scheme's investment strategy including the need to accelerate the pace of risk reduction.

Although the new funding Code is not yet in force, the Regulator considers it good practice for trustees to consider the steps that can be taken now to align (even if broadly) with the key principles of the draft Code, particularly those underpinning the definition of the low dependency funding target, investment allocation and funding basis (see Chapters 3 and 4 of the draft Code).

Where a scheme's trustees have not yet agreed a long-term funding target with their scheme sponsor, they are urged to do so as a priority.

Funding below technical provisions

For scheme's funded below their technical provisions, trustees focus should be on bridging this gap first. They may need to re-visit their technical provisions to ensure they remain aligned to their scheme's long term funding target. Trustees in this position are also reminded that:

• any risk-taking should be supported by the employer covenant and should reduce as the scheme gets better funded or matures; and
• any deficit should be recovered as soon as the employer can reasonably afford.

The Regulator's guidance from previous years continues to apply and is repeated (with minor amendment) in various tables at the end of the statement, which vary depending on the nature and circumstances of a scheme. The Regulator also recognises that the appropriate approach will also vary depending on a scheme's recent experience.

Investment considerations

The key change in market conditions in 2022 was the rise in long-term global interest rates, which meant that bonds performed poorly compared to equities, specifically in the UK. In light of changes in funding levels and the performance of different asset classes over the past year, trustees are reminded of the need to:

• review their scheme's investment strategy to ensure it remains appropriate;
• review the split between matching and growth assets;
• consider the scope to accelerate de-risking and increase levels of hedging (where appropriate);
• consider the need to reduce leverage in geared LDI arrangements; and
• speak with their advisers about managing illiquid assets given the significant change in market conditions.

Trustees are also reminded of the need to review the operational and governance arrangements that support their investments and to address the points covered by the Regulator's guidance on leveraged LDI.

Covenant considerations

Trustees are reminded that although their scheme may currently appear less reliant on the employer covenant, this can change quickly if their investment strategy is not resilient to market changes or because the health of the employer's business deteriorates. Trustees should undertake scenario analysis to understand their scheme's sensitivity to such changes and how quickly covenant dependency can increase.

Trustees are also reminded of the need to understand the key factors affecting their employer's resilience and to be alive to the impact of the current economic environment on their employer covenant, including the impact of higher interest rates, higher energy costs, potential reduction in demand and higher inflation.

Where there has been a significant improvement in a scheme's funding position, trustees may consider it appropriate to amend the scope of the covenant assessment supporting their scheme. For example, the statement suggests that the assessment could be less focused on uses of free cash flow if no recovery plan is required, and more on the longevity of the covenant and the potential impact of environmental, social and governance (ESG) risks.

The Regulator plans to publish proposed changes to its August 2015 guidance on employer covenant and other related guidance later this year. The new guidance will provide more detail on covenant visibility, reliability and longevity, how to treat guarantees for funding purposes and more information regarding ESG risks and how these can be factored into the covenant.

Other considerations

Alongside funding, investment and covenant considerations, the Regulator:

• reminds trustees that future mortality projections (which are starting to take account of the fact that mortality rates seem to have stabilised at a rate higher than in 2019) need to be interpreted with a degree of caution, particularly as it will take time to see how the new trends develop. It may be appropriate for trustees to adjust their mortality assumptions, but any changes must be appropriate and justifiable; and
• confirms that its views on the challenges posed by current high inflation rates on the calculation of benefits and benefit increases built into valuation calculations and in deriving assumptions such as salary increases, remain unchanged from last year's statement (see 'Inflation' section).

Revising recovery plans and contingent assets

Where a scheme is ahead of plan and considering whether to reduce or stop deficit recovery contributions (DRCs), the Regulator expects trustees to first consider the following:

• if their covenant has weakened, or was already weak, they should ensure the level of prudence in their technical provisions remains appropriate and the level of investment risk is supported by their current assessment of the covenant;
• if their scheme has a technical provisions deficit, they should consider reducing the remaining length of the recovery plan before reducing the level of DRCs. This is particularly important where the recovery plan remains longer than six years, where a scheme is mature or where there are concerns about the longer-term ability of the employer to support the scheme;
• if their recovery plan makes an allowance for asset returns in excess of the technical provisions assumptions, trustees should consider reducing the additional risk from this before reducing DRCs; and
• if shareholder distributions exceed DRCs or covenant leakage is material, it is unlikely to be appropriate to reduce DRCs while a technical provisions deficit persists

If a reduction is agreed, trustees are strongly encouraged to put in place a mechanism to ensure that contributions recommence if there is a reversal in funding levels.

Refinancing risk

Trustees need to be alert to the risks associated with rising interest rates and tightened risk appetites of lenders, which may result in materially changed terms and conditions when existing debt facilities require refinancing.

Re-financing risk should be incorporated into a scheme's covenant analysis and information sharing agreement and monitoring, as it may impact future covenant support, potentially place more restrictions on management's actions and affect the scheme's position as a creditor. How a scheme approaches this depends on the expected timing of the refinancing:

• where the refinancing is expected to be well progressed prior to the completion of a valuation, the Regulator expects trustees to be fully engaged in the process. Trustees should refrain from finalising their covenant analysis until the terms of the refinancing are clear allowing them to be fully factored into the conclusions; and
• where refinancing will fall after the valuation date but still within the short term, for example within three years, trustees are expected to consider how it could affect future covenant support.

Open schemes

The statement also contains some specific guidance for open schemes. Such schemes may have seen a material reduction in the estimated cost of providing future service benefits and, given their immaturity, may have seen significant movements in funding levels.

The Regulator expects that trustees of open schemes are likely to be more focused on technical provisions compared to long-term targets/end games and may be maintaining greater covenant reliance for a longer period than their closed counterparts.

As far as de-risking is concerned, the Regulator recognises that immature and open schemes that have seen significant funding improvements could have a wide choice of strategies available, including retaining higher levels of risk compared to more mature schemes, as well as potentially having opportunities to reduce risk.

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.