Article 29 April, 2021

Long-term funding: are we on the right track?

As we emerge from a COVID world, agreeing on a long-term funding target is a key 2021 focus for trustees. Galvanised by the Pensions Regulator (TPR)’s new Defined Benefit (DB) Funding Code of Practice, trustees and sponsors must address the maturing status of their DB schemes. TPR expects trustees to determine a clear journey plan towards a lower risk position as they close in on their goal.

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As we emerge from a COVID world, agreeing on a long-term funding target is a key 2021 focus for trustees. Galvanised by the Pensions Regulator (TPR)’s new Defined Benefit (DB) Funding Code of Practice, trustees and sponsors must address the maturing status of their DB schemes. TPR expects trustees to determine a clear journey plan towards a lower risk position as they close in on their goal.

With a second consultation on the new Defined Benefit Funding Code due later this year, there is an increasing spotlight on trustees in setting their long-term funding objective and developing a clear plan to achieve it. Whilst the finer details of the code are still being developed, we believe the scheme-specific focus on getting to the end-game is a vital step forward in improving security for DB scheme members. That said, trustees should be considering the regulatory direction of travel in their decision-making today, particularly relating to investment strategy.

The last few months have witnessed a favourable uptick in scheme funding-welcome news after the significant swings in scheme deficits throughout 2020. However, looking forward, the headline topic for trustees’ agendas is where they go from here. Is the goal still Technical Provisions or self-sufficiency? Is Buyout still a distant aspiration or could it have now become a tangible goal? What about commercial consolidators or the emerging role of DB Master Trusts?

The veritable minefield of end-game options may present a challenge for trustees to navigate, particularly where they are also balancing uncertainty with the extent of support from the sponsoring employer. However, some simple steps can help trustees design a framework that ensures consistency with regulatory expectations, whilst enabling effective decisions today, that are aligned to the future:

Select a destination

Historically, the funding gap (or deficit) to an end-game destination has loomed so large to not merit much thought. However, with positive progress in scheme funding over the last year, coupled with accelerating maturity profiles, trustees should rethink their goal and what is achievable.

Today, many trustees start by asking if the scheme could buyout in ten to twelve years. Increasingly, the answer is maybe… and therefore they should factor this into the investment strategy and journey plan today. However, if this is not achievable, the next question should be how well funded could/should the scheme be in ten years on a ‘Low Dependency’ measure (otherwise known as self-sufficiency).

In their consultation document, The Pensions Regulator (TPR) proposes that the timeframe to reach full funding on a Low Dependency basis is once a scheme reaches ‘significant maturity’. TPR defines ‘significant maturity’ as a liability cash-flow duration of 12-14 years, which they consider broadly equivalent to when the scheme is paying out 5% or 6% of its liabilities as benefits each year. Trustees need to get a handle on where their scheme lies relative to these milestones and how quickly they are accelerating towards them.

Scheme maturity also affects the ‘gap’ between Low Dependency and Buyout. Insurers typically place a higher value on non-pensioner liabilities, so the overall cost of Buyout tends to Low Dependency as members retire (as illustrated below). Transfers out and early retirements also increase scheme maturity, reducing the leap to Buyout further. If your scheme has seen significant activity in these areas, Buyout might be closer than you think…. Understanding the scheme’s maturity will assist trustees in effectively setting their destination and future-proofing against the current regulatory direction.

“We have been helping trustees design solutions which meet their need for return whilst managing key risks in the liabilities and tackling increasing cash flow demands.”

Review the journey plan

With the destination in mind, trustees should rethink their journey plan. For example, are they targeting the right investment return today or taking too much risk to achieve that return target? Are they not targeting enough return and therefore introducing an increasing reliance on the Sponsoring Employer in the future? Is the scheme likely to pass the new Fast Track thresholds and what are the implications of aligning vs. going bespoke?

For example, we are seeing schemes that, having followed a neat de-risking framework, are typically anchored to full funding on Technical Provisions or a measure of self-sufficiency. But the measure of the liabilities set by these schemes may not be consistent with what the DB Funding Code expects.

Let’s consider a scheme that has de-risked materially in recent years, running a low level of return aligned to the Actuary’s assumptions. This would appear to be a relatively comfortable position. However, current expectations for an acceptable end-game under the new DB Funding Code may assume a more prudent position (as illustrated below). The result is a funding shortfall which introduces a fresh dilemma for the trustees. Do they need to extend the timeframe to target their end-game? Do they need to re-risk the scheme’s investment strategy? Or do they rely on more contributions from the Sponsor? None of these options is desirable.

There will be times where scenario testing alternative journey plans is vital to inform both the trustees and sponsoring employers of what is possible today and in the future. This is vital in order to demonstrate an integrated approach to risk management and to avoid being anchored to historic decisions. Crunching the numbers also ensures that the scheme is targeting an appropriate investment return today and avoids de-risking too soon or indeed too quickly. Being flexible is key to ensuring that trustees stay on the right track to reach their end-game destination. Indeed, it might even be time to change track and be more certain of arriving on time.

Don't get blown off course

For most Defined Benefit schemes, the journey to their endgame is not without risk. TPR expects schemes to reduce investment risk as they mature. However, trustees must balance de-risking against achieving the long-term funding target. De-risking too soon can have a profound impact, extending the timeframe to the ultimate destination and placing greater reliance on the sponsoring employer.

Crucially de-risking isn’t the blunt instrument it once was and needn’t mean sacrificing return. We have been helping trustees design solutions which meet their need for return whilst managing key risks in the liabilities and tackling increasing cash flow demands.

The three steps outlined here provide a robust framework to reach your end-game without getting blown off course. Importantly we find this supports more effective governance with scope to adapt the journey along the way and navigate what is likely to be a volatile path ahead.

 

This article constitutes a financial promotion and has been issued and approved by River and Mercantile Solutions, a division of River and Mercantile Investments Limited which is authorised and regulated in the United Kingdom by the Financial Conduct Authority and is a subsidiary of River and Mercantile Group Plc (registered in England and Wales No. 04035248).
Please note that this communication is directed at, and intended for, the consideration of Professional clients. Retail clients must not place any reliance upon the contents.
The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a guide to future performance. Changes in exchange rates may have an adverse effect on the value, price or income of investments.
Registered office: 30 Coleman Street, London, EC2R 5AL
Registered in England and Wales No. 3359127
FCA Registration No. 195028

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