The Pensions Regulator’s executive director for regulatory policy, Andrew Warwick-Thompson, speaks to Sebastian Cheek about the watchdog’s approach to scheme funding, its powers to police employer obligations and consolidation among schemes.
What is TPR’s approach to DB scheme funding at the moment, given the post- Brexit, lower for longer and QE-fuelled world?
Our approach to scheme funding is exactly the same as it was before Brexit. It is wellestablished and really hasn’t changed as a result, either of the market volatility coming up to the Brexit vote or indeed the further falls in yields post-Brexit.
The reason for that is pension schemes plan and invest for a very long period of time, so schemes will be paying out benefits for the better part of the rest of the century. Our focus therefore, is on whether they are able to meet the cash flows, i.e. the pension payments, as they fall due. So it is not the case that they necessarily need to be fully- funded now on any particular basis. What you need to see is a clear plan agreed between the trustees and the employer about how those future cash flows will be met. Now, at the moment, the price of those future cash flows is very high because not just gilt yields, but returns on all asset classes are lower than they have been assumed to be historically. So the discounting used for those cash flows means the deficit numbers are higher than they have been in the past.
But that is not necessarily going to be the case forever. Economic conditions will change many times, I’m sure, over the rest of the century during the period that schemes will be paying out benefits.
Have you seen a lot of schemes reviewing their recovery plans as a result of Brexit?
We have not seen any signs of panic. But I expect that those schemes that are completing their valuations this year are likely to have seen their funding position deteriorate since they completed the last valuation three years ago.
So we will expect to see trustees and employers having further discussions about whether their recovery plan period is the right length – and whether their deficit recovery contributions are at the right level. We made very clear in our annual funding statement this year that in the majority of cases, we think the current level of deficit recovery contributions (DRCs) is maintained and in those cases where it is necessary, DRCs will be increased.
The reason for that is our analysis of dividend payments. In 2010, dividend payments were running at about six times DRCs whereas in 2016, our analysis shows it’s running at around 11 times DRCs. So it’s quite possible for the majority of companies to increase their DRCs, albeit at the expense of reducing their dividend payment.
So is the regulator’s approach that if dividends are going up this amount then there’s no excuse for companies not to help with the deficit recovery?
Our view is that in the majority of circumstances, the deficit can be met by sponsoring employers by increasing their deficit recovery contributions where necessary.
Now, there are a minority of employers where both they and the scheme are distressed and that is typically characterised by a scheme that has a significant deficit and an employer that has a very weak covenant. Under those circumstances, we have always and will continue to engage with those schemes as necessary to help them reach a sensible funding and recovery plan.
What does that engagement involve?
We use the data that we have on schemes and employers to identify those schemes we believe are most at risk. Our DB case teams engage with them proactively to help them and we are also able to support those schemes and employers who approach us for help, so we can deal with them reactively.
Some people in the industry believe measuring liabilities on a mark-to-market basis using gilts is flawed as it gives an unrealistic picture of present liabilities. What are your thoughts?
The majority of people who are commenting on this don’t understand how scheme valuations are done. A valuation which is done on a buyout basis, which is the basis often quoted in the media, is calculated on a gilts basis because that’s how insurance companies price buyout contracts.
But a scheme-specific valuation is done on the basis of the assets actually held and the investment strategy being followed by the scheme. So their discount rate can be adjusted to match the anticipated returns on the investments they actually hold now and are likely to hold over the life of the scheme. That might include some gilts, but it will almost certainly include equities, possibly some property, maybe some infrastructure, some alternatives. So this idea that a scheme-specific valuation has to use gilts only is just not true. And that is why you generally get such a huge difference between the buyout valuation and the scheme-specific valuation.
Solvency regulations require insurance companies to be able to back their assets and liabilities in a particular way and therefore they’re obliged to discount that way. A pension scheme is not. A pension scheme can invest in a very wide variety of assets and so it should be discounting the future cash flows in a manner that is appropriate to the assets that they actually hold. I’m not saying that it’s the best method, I’m saying that no one has come up with a technically better and widely-accepted method of doing this so far as I have seen.
What is TPR’s approach to this greater move by pension schemes into alternative asset classes to obtain yield?
Well, we expect trustees to consider the security of the assets that they hold. They’re also under an obligation to consider diversification of risk and so in principle, moving into asset classes other than bonds and equities may well be the sensible thing for them to do.
However, we would expect significant changes in the investment structure of a DB pension scheme to be discussed between the trustees and the employer, making sure that any increase in the risk of the scheme as a result of that change in investment exposure is understood and agreed by the employer – since it is the employer who essentially underwrites that risk.
