Sponsors are not required to cover all conceivable pension risks and they may embrace a degree of risk when funding their defined benefit (DB) pension schemes.
Indeed, The Pension Regulator’s Code of Conduct on DB Funding states that sponsors and Trustees ‘…may wish to embrace a degree of risk in seeking opportunities to capture potentially significant associated rewards for both the scheme and sponsor…’.
Most sponsors do exactly this and the funding plans for the vast majority of DB schemes have some exposure to covenant and investment risk. Few sponsors fund on a risk-free solvency basis.
However, despite this widespread running of investment and covenant risks, there are seemingly very few sponsors and Trustees who in turn effectively integrate risk into their decision making.
In this note, we explain how sponsors and Trustees can ‘Take Back Control’ of their own funding plans and investment strategies, and in turn help safeguard the security of members’ benefits.
Traditional approach to the actuarial valuation
A typical actuarial valuation involves the following steps:
The Trustees carry out an independent review of the sponsor’s covenant to assess the strength of the sponsor and its ability to support the scheme.
The scheme actuary advises on assumptions, margins for prudence and the technical provisions.
A key assumption is the prudent discount rate. This determines the size of the technical provisions and the amount of any sponsor contributions.
Actuaries have different approaches to discount rates and, depending on the views of their actuary, a scheme may use a single discount rate for all its liabilities, or separate pre and post-retirement discount rates. Further, it may adopt a yield curve approach, have a discount rate expressed as equity returns less a margin, or gilt yields plus a margin, or something else entirely.
The actuary will take account of covenant strength when advising on a margin for prudence to arrive at a prudent discount rate. Importantly, there isn’t a single objective way of transposing covenant score into a suitable margin for prudence, and again, different actuaries will adopt different approaches.
Negotiations with the sponsor
The sponsor and its advisors review the Trustee funding proposal and test the assumptions and calculations.
Agreement on funding
After a period of negotiation, most sponsors and Trustees reach agreement on the actuarial valuation and an updated funding plan.
Problems with the traditional approach
The approach described above does not assess the impact of risk on members’ pensions. As risk isn’t measured, sponsors and Trustees cannot consider it when making decisions on funding and investing.
Instead, the approach relies primarily on the use of ‘actuarial judgement’ to decide on suitable technical provisions and the amount of risk to embrace. Moreover, the actuary doesn’t carry out an assessment of risk and the impact this has on member pensions.
Technical provisions and contributions calculated under this approach are arguably somewhat arbitrary. Different actuaries can, and will, recommend different technical provisions and deficit contributions to the same DB pension scheme.
The Pensions Regulator wants sponsors and Trustees to work collaboratively, but it’s not uncommon for funding negotiations to be difficult, with mutual incomprehension on both sides. For example, the Trustees to a scheme with a weak covenant may want a conservative, gilts based investment strategy with correspondingly large sponsor contributions, while the sponsor may be more willing to have a funding plan that embraces risk. Neither will have considered the actual impact of their proposals on members’ benefits.
The financial impact of getting this wrong can be substantial. For example, a conservative actuary may embrace less risk than the sponsor and Trustee may otherwise have agreed. The consequence of this will be larger sponsor contributions, less reinvestment into the business, reduced dividend payments, etc.
Taking Back Control
We can help you redress this balance by advising a framework that includes the following steps to help sponsors and trustees ‘Take Back Control’:
Actuarial assumptions, covenant risk
As set out above the scheme actuary advises on actuarial assumptions and the trustees carry out an assessment of the sponsor covenant. The covenant review and actuarial assumptions are discussed openly and transparently between the sponsor, Trustees and their respective advisors.
Integrated Risk Management (IRM) modelling to assess risks
A stochastic IRM modelling exercise is carried out to assess risk and calculate the impact this has on member pensions. The IRM Modelling exercise should capture all three drivers of benefit security (funding, investment and covenant) and the inter-relationships between them.
The IRM modelling exercise may reveal, for example, that the sponsor and Trustees can only be 70% certain that all pensions will be paid in full.
Agree funding objectives
The sponsor and Trustees discuss and agree on a suitable funding objective.
As the purpose of a DB pension scheme is to pay all pensions when they fall due, these discussions should focus on member outcomes and not metrics like ‘funding level’, ‘split discount rates’ or ‘5%, 3-year deficit value-at-risk’.
Examples of funding objectives that consider member outcomes and allow for prudence include:
- Technical provisions set so that when fully funded can be 90% certain that all pensions will be paid in full, or
- Sponsor contributions calculated so that the expected proportion of future pension payable is 95%, or
- Fund so that 100% certain that all pensions will be paid in full, whatever happens to the sponsor.
The last objective would mean funding on a risk-free solvency basis. This would, of course, be best for members but sponsors are not obliged to fund on this basis and, in any case, this may not be affordable.
Calculate technical provisions and future contributions
IRM modelling is used to calculate the reserve needed to meet the funding objective agreed above.
This target reserve is the technical provisions. If the scheme is in shortfall then the sponsor and Trustees will have to agree on deficit contributions.
The technical provisions and contributions calculated under this framework are derived directly from the funding objective set by the sponsor and Trustee and not by ‘actuarial judgement’.
In this note, we explain how sponsors and Trustees can set funding objectives that consider member outcomes and integrate the confluence of investment and covenant risk. These funding objectives can be used to determine technical provisions, sponsor contributions and allow sponsors and Trustees to ‘Take Back Control’ of DB funding.
In addition our IRM modelling framework can help with difficult questions such as:
- “Are members’ better off if we invest conservatively and accept lower returns or is it better to invest aggressively and target higher returns for a shorter period of time?”
- “Should we accept an offer to exchange some deficit contributions for a contingent asset?”
- “When are the best times to de-risk and how much de-risking should we carry out?”
We would be delighted to meet with you in person to discuss our framework in more detail and show how it could be applied to your pension scheme.