making pension scheme funding work proven techniques to …€¦ · manage cash demands the 2013...
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www.pwc.co.uk/pensionsPensions Focus
May 2013 Page 1 of 9
Making pensionscheme funding workProven techniques tomanage cash demands
The 2013 annual funding statement by the Pensions Regulator (tPR) reiteratedits view that the scheme-specific funding regime remains fit for purpose. TheRegulator believes the regime contains enough flexibility to allow employers tocope with challenging economic circumstances when funding the defined benefitpension schemes that they sponsor.
This is true, but some employers are not taking advantage of the flexibilitywithin the current regime. There is a wide range of alternative approaches tofunding a pension scheme deficit and times are changing. Employers need tofully understand the options to reach the best possible agreements with trusteeson recovery plans where the required level of cash contributions and otherfinancing is decided.
Increasingly, the focus for trustees will be on the ability of employers to supportreturn-seeking investment strategies, and downside mitigation in the event thatthings turn out worse than expected. But it is up to employers to take the lead infunding discussions to avoid what tPR describes as ‘reckless prudence’ creepinginto the perspective of trustees and their advisers.
This Pensions Focus looks at recent developments and innovations in schemefunding that you can deploy in the run up to and during funding negotiations.
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The changing landscape
2013 actuarial valuations
Market turmoil means 2013 valuations are likely to prove even more challenging than2012 ones. We thought employers on a 2012 three-yearly valuation cycle were unlucky –having faced valuations at two of the worst times possible in recent years (2009 and2012). But they were unlikely to face the significant increase in deficits that employerswith 2013 valuations will be considering – 2010 was a relatively good year for valuationsbut 2013 conditions will likely result in much higher deficits without intervention in howthe deficit is calculated. As can be seen in the graph below, for an illustrative £1bnpension scheme the deficit could have increased by as much £200m in 2013 having beenbroadly fully funded on a going concern measure in 2010.
Consider the sponsor – a new statutory objective for tPR
There are proposals for a new statutory objective for tPR to recognise the need foremployers’ sustainable growth. While it is not clear exactly how this new objective willoperate, it should improve the negotiating position of the employer in fundingnegotiations.
Demonstrating that deficit repair contributions are at the limit of affordability by theemployer is a powerful way to manage the cash contributions to the pension scheme. Inthe past, the employer needed to satisfy their pension scheme trustees and tPR thataffordability had been estimated in a way they considered acceptable. The new statutoryobjective is likely to reduce the challenge against well-articulated affordabilitylimitations – even where cash is available, evidenced explanation that internal uses ofthe cash are in the long-term interest of the sponsor, and therefore the pension scheme,are likely to gain more traction than before.
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Negotiation strategies
1. Making prudence explicit
A calculation of ‘best estimate’ or ‘nil prudence’ scheme liability values is now arequirement for all valuations. This means allowances for prudence are explicit and canbe compared across schemes and valuations. We see a very broad range of prudencemargins (from 10% to 40% of liabilities). Often, there is also some double-counting ofprudence where, despite the label ‘nil prudence’ or ‘best-estimate’, those assumptionsactually include some prudence, ultimately resulting in inflated company cashcontributions.
Well-briefed sponsors understand the areas that contain implicit prudence and it is oftenthese margins that are easiest to remove during negotiations.
2. Deploying a strong covenant
Our surveys have shown that companies with strong covenants do not always deploy thisfeature to reduce the amount of prudence in deficit assessments. This may be deliberatebecause those companies can afford to let that prudence by – but it may also be a missedopportunity.
3. Interest rate reversion
The Bank of England has recognised that Quantitative Easing has increased deficits indefined benefit schemes, arguably on a temporary and artificial basis, yet tPR hasappeared to take a dim view of explicit allowance being made for this in scheme fundingdeficit calculations. Instead it prefers to see any allowances via recovery plans and onlyin cases where some form of contingency is provided.
Given this, it is not surprising that few schemes appear to be adjusting for long-terminterest rate reversion to historic levels, preferring other approaches instead, e.g. longerrecovery plans and higher expected asset returns.
But where the underlying scheme investment strategy has been carefully structured toreact to a belief that interest rates will ultimately rise, such as the ‘stabiliser’ strategieswe have implemented which both reduce exposure to negative market and inflationmovements while still retaining an explicit strategy to benefit from rising interest rates,then it would be reasonable to allow for this in actuarial valuation and risk managementplanning.
4. Post-valuation experience
Schemes with 2013 valuations should continue to monitor the market. Legislationpermits movements in markets to be allowed for in recovery plans and, where the impactof this is an improved funding position that is not expected to be temporary, it seemssensible to allow for this rather than risk overfunding schemes. At the time of writing,post-valuation experience may be especially valuable for pension schemes withvaluations at 31 March 2013. Tools such as Skyval (see later) make it easy to check suchupdates accurately and in real time as the period following the valuation date unfolds.
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5. Asymmetry of surplus and deficit
If you are concerned that allowing for post-valuation experience can cut both ways, thereis a logical argument for why only upside should be considered and short-term downsideignored (or at least rolled over to the next valuation).
Pensions funding is typically asymmetric for sponsors. While there is a deficit, thesponsor is on the hook. But if a surplus arises, it is not usually possible for the sponsor toobtain a refund. In a scheme funding regime which requires one-way prudent pre-funding with no refund in case of over-shooting, it is justifiable to hold over bad newsbut take account of good news when determining whether to adjust recovery plans forshort-term movements.
6. Recovery plan structuring
Recovery plan assumptions are not required to be prudent and tPR has been keen tostress that there is flexibility in recovery plans to deal with current economic conditions.Some of the recovery plan trends that we’re seeing more frequently are:
lengthening recovery plans, e.g. 15 years plus – tPR is keen to stress that theprevious ten year reference point should not be relevant to recovery plandiscussions
reshaped plans, e.g. more back-end loading conditional arrangements, e.g. linked to business performance, and contingent arrangements, e.g. additional cash if recovery plan assumptions not
met.
Reducing liability values
7. Asset-led discount rates
The discount rate used in an actuarial valuation is one of the most importantassumptions. Interest rates and investment returns have no direct impact on thepensions paid to individuals in a defined benefit pension plan as long as the sponsor issolvent. But the rate assumed to discount the liabilities to a ‘present value’ is critical inthe assessment of any shortfall or surplus in the pension scheme today.
Traditionally, the setting of the discount rate assumes that pension schemes willautomatically change their investment strategy as members retire – often into gilt orbond-type investments and so assumptions about the associated returns which go withsuch assets.
In contrast to this “member-led” approach to discounting, our “asset-led” approachinstead has regard to the actual long-term investment strategy, allowing better (but stillprudent) allowance for future asset returns and so not overstating cash contributionrequirements.
Member-led discounting
Two discount rates, one applying before retirement and one after Assumes a switch to low-risk assets as members retire Prudence increases as scheme matures Doesn’t reflect actual investment strategy Can drive trustee behaviour to de-risk inefficiently Overstates deficit and resulting cash needs
Alternative asset-led approach
Reflects long-term investment strategy Better recognition for long-term asset returns Investment strategy drives funding – avoids tail wagging the dog Intrinsically links covenant to funding Transparent – better decision-making More robust from one valuation to the next
PwC - May 2013 Page 5 of 9
Switching to an asset-led approach can substantially reduce the “reckless prudence” inliability values, in a way that is entirely consistent with the objectives of the pensionscheme. We estimate that funding UK pension schemes in this way would reduce totalUK employer cash requirements by at least £5bn a year.
8. Getting into the detail
Years of overlaying legislation has made calculating members’ pension benefitsaccurately exceptionally difficult in some cases.
Traditional valuation systems have been edited, adjusted and in some cases had severalapproximations applied, to try to maintain a close enough answer as more legislation hasbeen added over the years. Carrying out a fresh look at the pension scheme data, rulesand administration systems can yield some unexpected results that have been buried inyears of calculations.
The need to ensure that members’ benefits are paid in full means that historicsimplifications are more likely to lead to over-estimation of liabilities. It is possible that aliability reduction of anywhere up to 5% can be achieved simply by taking a drains-uplook at the benefit specifications and formulas used for actuarial valuations in moredetail. This sort of analysis can be an easy win for sponsors looking to ensure that nomore than is required is being paid to the pension scheme, or onward to members viahidden or unknown discretions or administration simplifications.
9. Are gilt yields the right anchor for discount rates?
One considerable area of flexibility in pension scheme funding is the baseline for settingthe discount rate used to evaluate the pension scheme liabilities. Government bondshave been the building block of choice for many schemes, meaning the pension schemevaluation will often default to starting at these low rates, even if some investmentoutperformance is then added to reflect the true nature of the pension schemes assets.
There are other valid starting points for setting the discount rate. A proactive discussioninvolving the pension scheme sponsor and reflecting the actual investment strategy ofthe pension scheme early in the discussion (rather than asking what investment strategysupports an arbitrarily proposed discount rate assumption) gives employers a moreconsistent starting point for building the discount rate and avoids anchoring tounnecessarily prudent approaches.
There is a material difference between the yields on government bonds and otherpotential reference rates, such as corporate bond yields. Pension schemes that takeadvantage of some of the new opportunities to invest in higher yielding, butappropriately secure, investments may be able to use these returns as the starting pointfor discount rate discussions, providing a more accurate evaluation of the pensionscheme liabilities.
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Increasing assets
10. New developments in asset-backed contributions
The use of asset-backed contributions (ABCs) has increased lately, as employers facelarger cash contribution demands and instead turn to alternative means of financingtheir schemes.
In particular, we have seen: increased use of inter-group loans/receivables from overseas parents increased use of ABCs by smaller schemes greater understanding of structures by companies, trustees, banks and tPR reduced implementation costs better clarity on tax treatment, and ever more innovation, e.g. use of reservoir trusts for holding short-term cash
(enabling quicker tactical investment strategy changes and ability to reclaimsurplus).
It’s likely that ABCs will remain a focus for 2013 valuations. While ABCs can bedeveloped to suit scheme-specific circumstances, common advantages typically include:
immediate security for trustees – enabling financing over a much longer period reduced danger of trapped surplus, and covenant enhancing so supports, for example, return-seeking investment
strategy.
11. Internal hedges – spotlight on inflation
When scheme actuaries set funding assumptions, it is typically market forecast interestand inflation rates that are used. When setting an inflation assumption for example, thestarting point is often the difference between fixed interest government bond yields andthe yields on index linked government bonds less, perhaps a small adjustment to allowfor anomalies in gilt markets.
Our analysis of historical rates of such market-implied inflation vs actual inflation withthe benefit of hindsight shows that market forecast inflation has overstated actualinflation by over 1%p.a. on average. This is significantly larger than the typical correctionapplied for scheme funding purposes – so pension scheme inflation-linked liabilityvalues could be overstated by as much as 20%.
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PwC - May 2013 Page 7 of 9
There are various ways to recognise this: Reduce unnecessary prudence in the inflation assumption. Contingent inflation financing - where the employer agrees to fund inflation on a
pay-as-you-go basis. This means that required contributions are based on alower baseline inflation assumption with additional funding paid only to theextent that actual inflation is higher than expected. This removes the over-reserve for inflation in the baseline cash contribution levels but gives trusteescomfort that higher inflation will not result in an increase in the deficit.
Formalise the contingent financing in the shape of an internal hedge betweensponsor and trustee which, if structured correctly, can be recognised as an assetfor its future capital value under the more prudent scheme funding assumptions.
Final commentsThe economic outlook for pension schemes and their sponsors remain challenging withlittle respite predicted soon. But as we have highlighted in this Pensions Focus, there area number of options and strategies available to pension scheme sponsors, that ifdeployed at the right time and in the right way, can ultimately square the circle ofproviding good security to a pension scheme while giving employers suitable flexibilitywith their cash and other assets.
Understanding the new backdrop to funding valuations, being on the front foot and thenutilising proven techniques can bring about a good outcome for all stakeholders of thepension scheme, while embracing the new context that the Pensions Regulator hasrecently set out.
PwC - May 2013
Introducing SkyvalTurning data into decisions
We are excited to launch our new online pensions modelling tool, Skyval. It willrevolutionise the way companies and trustees manage, monitortheir pensions issues. Skyval allows users to perform in real
updates of funding and accounting actuarial valuations risk management analysis sensitivity testing under a variety of economic scenarios and what ability to
cashflows, and summary dashboard reporting on key pension scheme metrics.
Skyval is an exclusive platform with functionality and interfaces specifically designed tomeet theinclude output covering IAS19 accounting disclosures and benchmarking, investmentstrategy and pensions risk management, and scheme funding analysis. It is available tosupport advisbe able to directly access Skyval, providing access to information and analysis onlypreviously available through advisers.
Find ou
Skyval
May 2013
Introducing SkyvalTurning data into decisions
We are excited to launch our new online pensions modelling tool, Skyval. It willrevolutionise the way companies and trustees manage, monitortheir pensions issues. Skyval allows users to perform in real
updates of funding and accounting actuarial valuationsrisk management analysissensitivity testing under a variety of economic scenarios and whatability to drill down into detailed scheme and market information, includingcashflows, andsummary dashboard reporting on key pension scheme metrics.
Skyval is an exclusive platform with functionality and interfaces specifically designed torequirements of those involved in dealing with pensions issues
include output covering IAS19 accounting disclosures and benchmarking, investmentstrategy and pensions risk management, and scheme funding analysis. It is available tosupport advisory work and, for appropriate organisations, sponsors and trustees will alsobe able to directly access Skyval, providing access to information and analysis onlypreviously available through advisers.
Find out more
Skyval
Helps companies and trustees understand and mbenefit pension liabilities quickly and efficientlyCan be used directly in-house by selected employers and trusteesContains fit-for-purpose analysis to support decisionintuitive and readily accessible format
Page 8 of 9
Introducing SkyvalTurning data into decisions
We are excited to launch our new online pensions modelling tool, Skyval. It willrevolutionise the way companies and trustees manage, monitor and take decisions abouttheir pensions issues. Skyval allows users to perform in real-time:
updates of funding and accounting actuarial valuations
sensitivity testing under a variety of economic scenarios and what-ifsdrill down into detailed scheme and market information, including
summary dashboard reporting on key pension scheme metrics.
Skyval is an exclusive platform with functionality and interfaces specifically designed torequirements of those involved in dealing with pensions issues. This will
include output covering IAS19 accounting disclosures and benchmarking, investmentstrategy and pensions risk management, and scheme funding analysis. It is available to
ory work and, for appropriate organisations, sponsors and trustees will alsobe able to directly access Skyval, providing access to information and analysis only
Helps companies and trustees understand and manage their definedbenefit pension liabilities quickly and efficiently
house by selected employers and trusteespurpose analysis to support decision-making in an
For a further discussion on any of the issues raised in this bulletin, please contact your usual
PwC pension adviser or:
London
Raj Mody
020 7804 0953
Rosie Blackham
020 7804 3616
Richard Cousins
020 7804 3119
Steven Dicker
020 7213 4442
Marc Hommel
020 7804 6936
Paul Kitson
020 7804 8174
Brian Peters
020 7212 3353
Chris Venables
020 7212 1135
Alex Wilson
020 7213 1128
This publication has been prepared forgeneral guidance on matters of interestonly, and does not constitute professionaladvice. It is aimed only at companies withdefined benefit occupational schemes or athigh value trusts (those with assets/cash ofat least £10 million). You should not actupon the information contained in thispublication without obtaining specificprofessional advice. No representation orwarranty (express or implied) is given as tothe accuracy or completeness of theinformation contained in this publication,and, to the extent permitted by law,PricewaterhouseCoopers LLP, its members,employees and agents do not accept orassume any liability, responsibility or duty ofcare for any consequences of you oranyone else acting, or refraining to act, inreliance on the information contained in thispublication or for any decision based on it.PricewaterhouseCoopers LLP is authorisedand regulated by the Financial ServicesAuthority (reference: 221411).
© 2013 PricewaterhouseCoopers LLP. Allrights reserved. In this document, “PwC”refers to PricewaterhouseCoopers LLP (alimited liability partnership in the UnitedKingdom) which is a member firm ofPricewaterhouseCoopers InternationalLimited, each member firm of which is aseparate legal entity.
For a further discussion on any of the issues raised in this bulletin, please contact your usual
PwC pension adviser or:
020 7804 0953
Rosie Blackham
020 7804 3616
Richard Cousins
020 7804 3119
Steven Dicker
020 7213 4442
Marc Hommel
020 7804 6936
Paul Kitson
020 7804 8174
Brian Peters
020 7212 3353
Chris Venables
020 7212 1135
Alex Wilson
020 7213 1128
Midlands
Jeremy May
0121 232 2165
Christopher Massey
0121 265 5332
North East
Chris Ringrose
0113 289 4320
Richard Giles
0113 289 4988
North West
Peter McDonald
0161 247 4567
South East
Peter Woods
0118 938 3533
Scotland
Alison Fleming
0131 260 4352
West
Mark Packham
0117 928 1199
For a further discussion on any of the issues raised in this bulletin, please contact your usual
Christopher Massey
PwC pensions
For our commentary on market issues look at our new blog:
www.pwc.blogs.com/pensions
PwC pensions Actuarial HR Legal M&A Risk
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www.pwc.blogs.com/pensions
Risk Structuring Tax
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PwC - May 2013May 2013 Page 9 of 9