DB funding – Pensions Regulator 2023 annual funding statement

The Pensions Regulator has published its 2023 annual funding statement which is targeted at DB schemes undergoing valuations with effective dates between 22 September 2022 and 21 September 2023. It is also relevant to DB schemes undergoing significant changes that require a review of their funding and risk strategies and schemes that may be receiving requests for reduced contributions, amendments to contingent asset arrangements, and proposals for other uses of surplus.

General considerations

The majority of schemes currently undergoing a valuation will have seen an improvement in their funding level and the Regulator expects a significant number to have reached buy-out funding. Trustees should consider if their long-term targets remain appropriate, whether buy-out is viable or to examine other end-game options. Where employers request a reduction or suspension to contributions and/or trustees are considering discretionary pension increases in light of the recent rapid increase in inflation, trustees should take into account the scheme’s overall position, the resilience of their investment strategy to future financial market movements and the level of covenant support.

A minority of schemes will have seen a reduction in their funding levels, in particular in light of the gilt yield volatility in autumn 2022. Trustees should reset their funding and investment strategies to reach their long-term targets and should review their operational governance processes to ensure future resilience.

Trustees should recognise the economic uncertainty that will continue to impact scheme investments, scheme liabilities and employer covenants, including further interest rate rises, high inflation rates, volatile commodity and energy prices, and ongoing or new geopolitical instability.

Trustees must be satisfied that their long-term target remains appropriate and that their funding and investment strategies are aligned to it. Trustees should understand their scheme’s key risks and the effectiveness of their plans to manage those risks.

Re-thinking strategies – considerations

Funding

Where the scheme is fully funded on a buy-out basis, trustees should consider whether proceeding with a buy-out or running the scheme on is the best approach. If buy-out is the preferred option, trustees should plan how to put themselves in the best possible position to approach the market.

Where the scheme is fully funded on a technical provisions basis, but has not reached buy-out funding, trustees should review their long-term objective and their plans for transitioning their investment strategy over time to align with that objective. If the trustees have not yet agreed a long-term funding target with the employer, they should do as a priority. It would be good practice for trustees to consider the steps they can take now to align with the key principles of the Regulator’s draft funding code.

Where the scheme has a deficit on a technical provisions basis, trustees should revisit their technical provisions to ensure they are aligned with the scheme’s long-term funding target and focus on repairing the deficit as soon as the employer can reasonably afford. If the scheme’s funding position has regressed significantly over the past year, trustees should understand the reasons for this and re-build an appropriate funding and investment strategy.

Investment

The rise in interest rates over the last year means that many schemes’ asset allocations may have changed materially. Trustees should consider the implications for their investment strategy, particularly the split between matching and growth assets. Trustees should also review their operational processes and speak with their advisers about managing illiquid assets in light of the change in market conditions.

Covenant

Scenario analysis of different economic environments and their impact on funding positions will help trustees understand their scheme’s sensitivity to changes and how quickly covenant dependency can increase. Trustees should not overlook the short-term impact of the current economic environment on the employer covenant and should understand the key factors affecting their employer’s resilience. Trustees should ensure effective information-sharing protocols are complied with, and assess the impact of any changes. They should consider obtaining specialist advice, particularly where the covenant is complex or deteriorating, or has been materially affected by recent market events.

Other considerations

Longevity – The Regulator expects that many trustees will revise their mortality assumptions after taking actuarial advice. Trustees should ensure any changes are appropriate and justifiable.

Inflation – The Regulator’s views on the impact of the current high inflation rate, as set out in its 2022 annual funding statement, remain unchanged.

Recovery plans – If trustees are considering whether to reduce or stop deficit reduction contributions (DRCs) (whether as part of a formal valuation or otherwise), the Regulator expects them to consider the following:

• If the employer covenant has weakened, or was already weak, the level of prudence in the technical provisions should remain appropriate and the level of investment risk should be supported by the trustees’ current assessment of the covenant.
• If the scheme is in deficit on a technical provisions basis, the remaining length of the recovery plan should be reduced before DRCs.
• If the recovery plan makes an allowance for investment outperformance, this allowance should be reduced before DRCs.
• If shareholder distributions exceed DRCs or covenant leakage is material, it is unlikely to be appropriate to reduce DRCs while the scheme remains in deficit on a technical provisions basis.
• A mechanism should be put in place to ensure contributions recommence if the scheme’s funding level deteriorates.
• Suitable mitigation should be obtained if trustees consider it appropriate to agree to a request from an employer in distress for a reduction, deferral or cessation of contributions to support liquidity.

Refinancings – Refinancing risk should be incorporated into trustees’ covenant analysis and information-sharing and monitoring processes.

Key risks

The statement includes tables setting out, for each of 10 covenant categories, the key risks that the Regulator expects trustees and employers to focus on, and actions to take, depending on the scheme’s funding strength, maturity, and employer covenant strength.

Statutory funding regime changes

The Regulator now expects the legislation on the new funding and investment strategy requirements and the new DB funding code to come into force in April 2024. The existing code and legislative requirements remain in place until then. The Regulator plans to consult on proposed changes to its guidance on assessing and monitoring the employer covenant and other related guidance later this year.

How we can help

In addition to advising generally on the 2023 annual funding statement, Mayer Brown can advise trustees and employers on:

• The changes to the statutory funding regime and the Regulator’s new DB funding code.
• Scheme funding packages, including contribution ratchet mechanisms and alternative funding solutions such as contingent assets, asset-backed contribution arrangements and escrow arrangements.
• Legal aspects of employer covenant assessment and monitoring processes, including information-sharing protocols.
• Investment governance processes.
• Scheme buy-out, including preparations for buy-out.

For more information, please speak to your usual Mayer Brown contact.