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Andrew Warwick-Thompson – PLSA Hot Topic event: The Future of DB Funding

Wednesday 6 July 2016

Thank you to the PLSA for hosting this important event and for inviting me to speak to you today.

All of us in the pensions industry, and particularly those involved with defined benefit (DB) schemes, are working in challenging times. Market volatility, an uncertain economic outlook, and a host of legislative reforms, make an environment that is not always easy to navigate. The recent spotlight and media scrutiny on several high profile cases can add to a feeling of unease. And of course the EU referendum result has added an extra layer of uncertainty.

However, I’d like to stress that while we recognise that some schemes are facing challenging economic circumstances, we do not believe that DB pension schemes in general are facing a crisis. And it’s important that all of us in this field – regulators, trustees and the industry at large – remain calm.

TPR’s take on the current DB situation

As many of you know, we published our latest annual funding statement (AFS) in May. This shows our analysis of current market conditions and how sponsoring employers and trustees of DB schemes can agree their funding plans.

Our data suggests that despite market pressures, the majority of DB schemes completing valuations this year should be able to maintain existing recovery plans.

The AFS shows that schemes' deficits are likely to have increased in many cases. However, our data suggests too that for the majority of employers, profits have also increased. More than half of FTSE350 companies paid out ten times or more to shareholders than to their pension scheme. So, many employers should be able to maintain or even increase current deficit recovery contributions.

We recognise that some schemes and their sponsors are facing greater challenges. We are vigilant to these challenges, and indeed the wider challenges facing the country and economy – and we will be monitoring the situation closely, in conjunction with Government and other agencies. But in our view, there is no evidence that suggests a systemic affordability issue for employers with DB schemes. With careful management, the vast majority of employers with DB schemes should be able to meet their long term financial obligations to their schemes' members. And the PPF is there to provide a safety net to members of schemes where the sponsor becomes insolvent.

Brexit

I'd like to mention here our thoughts on what's been happening over the last two weeks, and the outlook for schemes post-Brexit.

We know that the referendum result was a shock to many people. The financial and stock markets reacted immediately and sharply, so we've certainly seen increased volatility, at least in the days immediately after the result. And this market volatility may affect some schemes' funding positions.

But pension schemes are long term investments and we urge trustees not to be overly focussed on the initial reaction of the markets and short term market movements.

We do appreciate that such deep uncertainty can make everyone nervous and we are publishing our initial post-referendum guidance for trustees very shortly. We are encouraging trustees to take a long term view – both of their expected risk and returns, and also how this interacts with their funding plans and risk appetite. Any impact of Brexit on scheme's funding and covenant will be scheme specific, and so trustees should consider the circumstances of their scheme and discuss this with their sponsor. If they have concerns they should also discuss this with their advisers.

Contingency planning is an integral part of the effective stewardship of DB pension schemes and we urge trustees to review their plans and how they interact with current circumstances.

We advocate an integrated approach to risk management and therefore we expect trustees to engage with their sponsoring employers, to review and discuss the potential impact of Brexit on risk appetites and strategies (both the trustees' and the employers') and to establish whether any changes are necessary.

We encourage schemes in particular to review their employer covenant over the coming months and how the results of Brexit are likely to affect it. Impact here is likely to be sectoral, as international trading conditions, particularly trade with the EU, will be likely to affect domestic and multinational business differently.

Furthermore, given that the full impacts of Brexit are likely to take some time to materialise, we expect the trustees and sponsoring employers to continue to work closely together on an ongoing basis to consider any material risks that might arise and any appropriate mitigations.

Trustees should work with their advisers to monitor developments and take steps to manage any emerging risks to the scheme.

In time, as the future implications of Brexit become clearer, trustees of schemes with money purchase benefits may also consider it appropriate to make changes to the investments included in the scheme's default arrangement, or the investments offered to members, including AVCs. But as many will have reviewed these in the light of the introduction of the new pensions flexibilities last year, this is unlikely to be urgent.

And of course TPR will continue to monitor the markets and other economic developments, and we will provide more guidance to trustees of both DB and DC schemes as necessary.

In the meantime, TPR will also continue to engage with European institutions such as EIOPA (European Insurance and Occupational Pensions Authority), while we wait for further clarity as to the nature of the UK’s new relationship with the EU and any transitional arrangements.

Our overall message to schemes is to stay calm, keep their investment strategies under review with a focus on the medium and longer term, and to discuss with their sponsor any potential implications on the covenant to the scheme. The information and guidance that is available to trustees in our Funding Code and in the AFS are still relevant.

And it's important to note that we don't want what's happening here in the short term to undermine the conversations that should really be happening between trustees and employers – that is, a conversation regarding the position of the scheme and the risks it is running and how best to manage these in an integrated way and ensuring that the scheme members are treated fairly.

Finally, we expect trustees to reassure their members. None of us wishes to see an increased flight of members and their pots from occupational pension schemes to unknown and possibly unsuitable destinations. Trustees need to be clear with their members that their stewardship extends to managing the scheme through good times and bad, and that they and their professional advisers are likely to be better placed to look after the best interests of members in the current uncertain environment than a member acting alone.

The Funding Framework

Let me now move onto the DB funding framework more generally.

It’s worth recalling that in July 2014 we were given a new statutory objective – which is specific to scheme funding – which is to minimise any adverse impact on the sustainable growth of an employer. So the framework is designed to strengthen the pension scheme but with appropriate flexibility to give employers the breathing space they need to grow their business.

It will not surprise you to know that this balance is not always easy to achieve, because at times those objectives can be in tension.

But the funding framework is specifically designed to be flexible; to allow us to strike that balance as much as possible, between protecting members of schemes – and the PPF – and not undermining the sponsoring employers' ability to grow their business by placing unreasonable burdens on them.

I want to emphasise that the system has been designed carefully: to be flexible enough to ensure that most schemes will pay out the benefits they have promised as they fall due, while allowing schemes to put in place recovery plans to reach full funding.

We recognise that some employers may not be able to increase their DRCs because they need to invest in their business for growth. In these cases we expect employers to discuss this openly with their trustees because it is important that employers are seen to be treating their pension scheme members fairly. We also expect trustees to question employers' dividend policies where DRCs are constrained.

We expect trustees and employers to work collaboratively to agree funding plans that meet both their needs. We believe that appropriate funding agreements can be reached in the vast majority of cases without the need for direct regulatory intervention.

We are always keen to explore credible new ideas with the pensions industry, and to work with sponsors and trustees to secure sustainable schemes that deliver good member outcomes over the decades to come.

Fundamentally, we believe the current funding framework is working as it was intended to by Parliament when we were given our new statutory objective.

Suggested improvements to the Funding Framework

It is nevertheless perfectly valid to ask if the current funding framework can be improved. And indeed the Work and Pensions Select Committee has announced a wider review of the DB framework to commence in the Autumn of this year.

The intense media coverage around BHS and British Steel has inevitably shone a spotlight on DB funding issues in general.

But it’s important to remember that the difficulties faced in situations such as this, and the potential outcomes for members, do not automatically mean the current system is broken. It is important too not to give the impression that when a business fails it is a disaster if the schemes falls into the PPF. That is, after all, precisely what Parliament intended should happen, and the alternative, that schemes are left orphaned and in a state of stress or distress, is likely to be far worse for the members.

Nevertheless, I think we can all expect that there will be questions raised again around employer affordability, how this interacts with the needs of the pension scheme and its members, how to avoid the PPF being 'gamed', and what options are available for dealing with stressed situations.

There will also be questions around whether the current regulatory framework is working as well as it could. At TPR we've been thinking about these questions for a while. While we do believe the current legislative and regulatory framework is working as Parliament intended, we can see areas where improvements could be made.

So ahead of WPSC inquiry this Autumn our Chief Executive Lesley Titcomb has written to the Committee outlining possible areas for improvement, and I’m happy to share those with you today.

They cover four main areas – information gathering, clearance and anti-avoidance, scheme funding and valuations, and scheme governance.

1. Information gathering

At TPR we use a variety of mechanisms to collect information, such as scheme returns, section 72 powers, and scheme valuation submissions. These mechanisms can sometimes be inflexible and a bit difficult to operate and enforce in practice. A more flexible information gathering power might be more effective, along with a general duty on parties to cooperate with the regulator. It might also be useful to have additional information gathering powers, for example the right to interview people who we believe may have relevant information to a case.

2. Clearance and anti-avoidance

Clearance is a voluntary process whereby an employer can ask us to confirm whether a planned corporate transaction would result in us issuing a Contribution Notice or a Financial Support Directive. These are sometimes referred to as our anti-avoidance powers. We don't suggest that this clearance should be made compulsory in all mergers or acquisitions. However, it’s worth exploring whether TPR should be more involved in certain circumstances, for example if the scheme is significantly underfunded or if a transaction will put a scheme at risk.

3. Scheme funding and valuations

The current framework for scheme funding aims to achieve a balance between protecting members, reducing risk to the PPF, and not putting an undue burden on employers. It is designed to be flexible and trustees and employers have a great deal of freedom in agreeing the appropriate level of funding for their scheme.

At the moment TPR can request that schemes and employers can re-draw these plans if we have concerns, and indeed we can impose a recovery plan or finding target if necessary.

But the flexibilities mean that there is a great deal of divergence in the approaches taken by schemes. We think there is room for more clarity in the framework to help schemes in this area. For example, there may be an argument for TPR to take on a more supervisory-type role, particularly for high risk schemes.

Another area for improvement may be the statutory timescales for scheme evaluations. We have suggested a more risk-based and segmented approach to requirements. For example more regular monitoring for high risk schemes. Less monitoring for well-run, well-funded schemes. Furthermore, with all the tools and technology available to schemes, it should now be possible for more 'real time' valuation information to be submitted.

4. Scheme governance

The fourth area where we have suggested some improvements are around scheme governance. Good governance is obviously vital to the effective running of pension schemes, irrespective of what type – DC, DB, Public service, hybrid. You may be aware that trustees of DC schemes are now required to indicate completion of the Chair’s statement in their scheme return, and will be fined if they don’t comply. In fact, just last week we published details of the first fine against a DC scheme for failing to produce a Chair’s statement.

That requirement to complete a Chair’s statement could be extended across all schemes, DB, public service and hybrid, as a way to promote good governance across the piece.

Finally, there is the subject of consolidation. There are a large number of unsustainable small schemes across the landscape, both DB and DC. Not all small schemes are run badly, but they clearly do face particular challenges. They tend to have lower levels of resources than large schemes and often have lower levels of engagement with their members and with us.

Consolidation may yield significant benefits for members, sponsors and the PPF. It would also mean that we at TPR would be able to target our efforts on a smaller pool of schemes. It’s a complex area, but given the potential benefits, we think it’s worthwhile exploring, and we have been in discussion with DWP and the PPF over this.

Conclusion

So, there are a few areas where we believe the system could be improved and we welcome the work of the PLSA Taskforce looking into this area in detail. But fundamentally, we think the funding framework is working as intended by Parliament and the vast majority of schemes will be able to meet their long term financial obligations to their members.

In conclusion:

  • yes, Brexit is causing uncertainty and volatility
  • yes, big cases are shining a light on funding challenges
  • yes, there may be room for improvement in the funding framework
  • but ultimately the system is working as Parliament intended that it should

Finally, we urge trustees, sponsors, advisers and members to stay focussed, stay calm, and to resist the impulse for a knee jerk reaction.

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