Funding valuations have often been a source of conflict, or at least robust negotiation, between companies and trustees. However, a small but growing number of companies are finding that working hand in glove with their trustees not only means a smoother valuation process but also leads to more effective funding and investment decisions.
In this Pensions Perspective, I look at how this relatively new model of working together has come about and explain why it can often make good sense from the sponsoring employer’s perspective. I am conscious that some of my readers may protest that hand in glove was the way companies and trustees used to work, before the Regulator and a scheme specific funding regime arrived on the scene in 2005. However, I would suggest that, in most cases, that working relationship was often one in which the company called the shots and the trustees followed. What I am discussing here is quite different.
Of course, a discussion about pace of funding is always likely to produce a difference of opinion between the company and the trustees. In most situations, the company wants to use cash to invest within its business. On the other hand, the trustees want to improve their scheme’s funding position as quickly as possible. Assuming the trustees do not have any special contribution powers, a suitable middle ground can usually be agreed if the covenant is strong. If the covenant is weak, there may be a limit to what the trustees can achieve anyway.
Either way, this kind of valuation negotiation involves time and resources and can easily become a significant distraction for senior management. It often also creates a climate of mistrust which, however the final valuation agreement is reached, can handicap the relationship between the company and the trustees in other areas for many years to come.
What has changed?
Three significant developments have changed the UK funding landscape over the past five years or so.
First, continuing DB closures mean that pension liabilities are genuinely a legacy issue for most employers, with their concern being purely how to best finance the deficit rather than any HR issues. As with any other legacy liabilities, companies need a plan to deal with them. For many companies the desire to reduce the volatility of the pension deficit on their balance sheet overrides concerns that, by de-risking sooner rather than later, they are going to need to pay higher contributions in the long run.
Secondly, five years ago most companies (and trustees for that matter) thought that gilt yields would revert to more historically normal levels and give a boost to funding, assuming their scheme was not completely hedged against interest rate risk. Nowadays, companies have accepted that current gilt yields (and the large deficits for which they are responsible) are probably the new norm and they certainly need to plan on that basis.
Finally, liability management used to be something of a dirty word for trustees, who saw it as action the company might propose but not something with which they would readily want to engage. However, many trustee boards are now prepared to work with the employer to offer members additional options (sometimes even proposing these themselves) and not necessarily on a cost neutral basis. The main concern of trustees now tends to be that the options are explained properly to their members.
What does this mean for funding?
The combination of the first two of these developments means that it is often companies who now take the initiative in seeking to develop a funding and investment plan based on a low-risk funding target and with an emphasis on de-risking (both automatically as well as opportunistically, if/when funding levels improve).
“…because we’re talking about a secondary funding target, it is also possible to build in some flexibility to the end-point of the recovery period…”
Whilst this should be music to the trustees’ ears, the strength of the low-risk funding target (typically based on the gilts yield curve with an additional margin of between zero and 50 basis points) usually means that the company needs to target full funding over a much longer timeframe than the 5 to 10 years typically used for the statutory technical provisions. This leads to the use of a secondary funding target (SFT) with a recovery plan of perhaps 15 to 20 years, but contributions that are still at least as high as those required to fund the technical provisions over a much shorter recovery plan. Inevitably, this longer timeframe will lead the trustees to consider longer term covenant analysis and to put more focus on the company’s longer term strategic plans. However, from the company’s perspective, that can often be a helpful change to the usual company/trustee interactions about the strength of covenant.
In addition, because we’re talking about an SFT, it is also possible to build in some flexibility to the end-point of the recovery period, which can help reduce the volatility of Company contributions. For example, rather than having a fixed end-point of 2033, contributions under the SFT could start at a level set using a 2033 end-point but remain at that level until that was not sufficient to reach full funding by 2038 (the period from 2033 to 2038 would often be referred to as the “landing zone” for the SFT).
The advantages of this SFT approach for the company are:
- much better trustee engagement
- more certainty about the future level of company contributions
- easier trustee agreement to a lower level of contributions, if the sponsor has genuine affordability constraints
- the company has a plan to manage the legacy liabilities, but there is time for economic conditions to improve and thereby reduce long-term funding requirements
- positive investor reaction to proactive management of pension risk
- more straightforward negotiations with the trustees at subsequent funding valuations.
In addition, this approach has better alignment with the Pensions Regulator’s thinking on funding and, perhaps even more crucially, with the recent White Paper proposals.
However, the advantages of adopting a hand in glove approach to funding and investment go well beyond more straightforward negotiations at future funding valuations. Indeed, depending upon how much of the SFT is prescribed, the outcome of future valuations may be largely mechanistic, i.e. simply reflecting scheme experience and changes in market conditions, and so become something of a sideshow.
“…the advantages of adopting a hand in glove approach…….go well beyond more straightforward negotiations at future funding valuations.”
Once a low-risk SFT is in place, it will naturally be used to help set investment de-risking triggers (trying to de-risk by reference to technical provisions is flawed because, as a scheme de-risks, so its technical provisions basis will need to be strengthened) and will also make it easier to plan “end game” solutions like buy ins or buyouts. In fact, the SFT becomes the yardstick by which a range of other possible actions are assessed.
An obvious example is the payment of transfer values, especially as members approach retirement. Against the technical provisions basis, paying transfer values for those close to retirement may appear broadly cost neutral (or even involve a small financial strain given that transfer values are not allowed to reflect commutation). However, against the low-risk target, there is likely to be a release of reserve, which highlights that both trustees and company should be happy with members wanting to transfer out, as long as they have considered their options properly (and of course received independent financial advice). Hence, trustees tend to be much more willing to provide transfer value quotations automatically to members as they approach retirement, and possibly provide them to all deferred pensioners on an annual basis. These forms of member communication will certainly increase the take-up rate for transfers out of the scheme.
More generally, and picking up on the third of our significant developments over the past five years, a hand in glove approach can often mean that trustees are more willing to contemplate new liability management options that help improve funding and/or shorten the time to reach full funding, like the introduction of a pension increase exchange (PIE) option at retirement.
Does it work in practice?
Emphatically yes, as demonstrated in the two case studies. The first involves a £500 million scheme where an SFT was introduced at the 2016 valuation, whilst the second looks at a £3 billion scheme which has now completed three valuations with an SFT and, as a result, a range of other projects using a hand in glove approach.
Case study 1
This scheme had assets of £500 million at its 2016 valuation date. The company’s covenant was strong, and also large compared to the size of the scheme. At the previous valuation in 2013, a conventional set of technical provisions had been used, with a dual discount rate based on gilt yields + 2.0% preretirement and gilt yields + 0.5% post-retirement. The company had been paying deficit contributions of £10 million per annum but, as the 2016 valuation approached, it was clear that the technical provisions deficit was going to be no smaller than three years earlier, namely at least £70 million. With this level of deficit, even extending the previous 8 year recovery plan by a further 3 years (i.e. to run for a new 8 years from 2016) would do no more than keep company contributions at the £10 million level.
Plans to de-risk the investment strategy had got bogged down in discussions about how such de-risking would change the technical provisions discount rate and therefore lead to additional company contributions. The company wanted to identify a better way of doing things and, ideally, develop a long-term plan to remove the DB liabilities from its balance sheet.
The key to unlock the stalemate was a new SFT basis which used gilt yields without any adjustment (the remaining assumptions were the same as for technical provisions). On this basis, the deficit was £200 million at the 2016 valuation date, but the company insisted that the recovery plan should be at least 15 years. An initial plan for automatic investment de-risking was also agreed, targeting a portfolio that by the end of 15 years would be 80% bonds and 20% growth assets (although dynamic de-risking triggers could mean this position is reached sooner). The trustees accepted that, with a gilts flat discount rate, it was reasonable to allow for out-performance of the assets over the recovery plan, starting with a margin of 1.5% above gilts in year one and reducing to 0.5% above gilts by the end of 15 years. On this basis, the amount of deficit contributions required over the 15 year period was just below £10 million a year.
In practice, the Company agreed to continue to pay (at least) £10 million of deficit contributions for the next 15 (or even 20) years. In return, the SFT included a 5 year landing zone. This means that, if at a subsequent valuation experience has been poor, the level of annual deficit contributions will not increase above £10 million unless or until that £10 million level is not sufficient to reach full funding on the SFT basis by 2036, i.e. 20 years from the 2016 valuation.
Whilst in one sense the current level of Company contributions is no different from the previous technical provisions approach, by committing to pay £10 million a year for a longer period the Company has agreed a new long-term approach to both funding and de-risking, and also achieved significantly more certainty that its contributions will not increase above £10 million a year for at least the next few valuations. The trustees are reassured because they are now clearly on a long-term journey which will ensure they become less dependent on the company’s covenant. And this hand in glove approach to funding and de-risking has already started to have spin-offs in other areas.
Case study 2
This company and trustees introduced an SFT, using a discount rate of gilt yields plus 25 basis points, in 2011, with the aim of reaching full funding by 2030. There was an appetite from both company and trustees to derisk investment strategy quickly, but also a recognition that such de-risking would mean it might take the best part of 20 years to reach a “self-sufficiency” position. Although described as a secondary target, the schedule of contributions put in place after the 2011 valuation was, in effect, driven by the SFT.
Despite the significant market developments of the subsequent 6 years, the 2014 and 2017 valuations were signed off with effectively the same schedule of contributions that was put in place at the 2011 valuation. There were some tweaks to the SFT around the edges (for example, more up-to-date and therefore weaker mortality improvements), but it was essentially the same SFT using the same 2030 end-point. The 2017 valuation was completed in less than 4 months from the valuation date.
This is a radically different outcome to the experience of many schemes at their two most recent triennial valuations. It reflects the SFT’s long recovery period and also the de-risking that has been taking place as part of the long-term plan. In addition, the SFT has helped facilitate a trivial commutation exercise, much more proactive communication to members about the size of their transfer values and the introduction of a PIE at retirement option (with the value of the uplift reflecting 70% of the value of the increases members give up).
When doesn't it work?
The other scenario where this approach may not be possible is when the trustees have special contribution powers, i.e. they can set the contributions unilaterally. However, from the employer’s perspective, a hand in glove approach is still probably the best way to address the management of scheme funding, especially if there are other things the employer can offer the trustees to provide security (the provision of which can be linked to the trustees continuing to work hand in glove).
The last word
For more details about how bac can support you in developing a long-term funding and investment de-risking plan, please contact us.
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