In conversation with The Pensions Regulator

Rowena Morris (RM): Welcome to the latest episode of our Covid-19 Business in Focus podcast, where we explore the business impacts of coronavirus. I’m Rowena Morris, a director at PwC, and I help clients prepare and respond to crisis situations, and I’m your host for this series.

In this episode, we’ll explore the impact coronavirus has had on pensions, and how the regulator is using its annual funding statement to address the crisis, and we’ll also look at some practical ways to protect and manage defined benefit pension schemes as we navigate this evolving situation.

Today I’m joined by Katie Lightstone and John Dunn, my colleagues from our pensions advisory business.

Katie Lightstone (KL): Hi Rowena.

John Dunn (JD): Hi Rowena. Morning everyone.

RM: We’re also delighted today to be joined by David Fairs, the Executive Director for Regulatory Policy Analysis and Advice at The Pensions Regulator. Hi David.

David Fairs (DF): Hello – thank you for inviting me.

RM: Thanks for being here. So to kick things off, John, please can you give us an idea of the impact that Covid-19 has had on pensions over the last few weeks?

JD: Yeah, and probably the easiest place to start Rowena is if we think about what people might be perceived to be the impact on pension schemes, assets and liabilities. So where are we? We’re at the end of April, and anyone that’s looked at global stock markets over the last couple of months will have seen some large falls. The global market was down by just over 30 percent at one point towards the end of March, and it’s now down between 10 and 15 percent depending on the day you look at it, so what we’re all seeing is really high levels of volatility at the moment.

The impact on defined benefit pension schemes though, will depend on the investment strategy that that individual scheme has adopted, and the extent to which the strategy has hedged the movement in pension scheme liabilities. Many defined benefit pension schemes actually adopt pretty low-risk investment strategies with lots of interest rate and inflation hedging, so the impact on the funding levels of these schemes is probably going to be a lot lower than people would expect by just looking at what’s happened to stock markets. But I’d caution and say that schemes that have taken bigger bets on stock markets and have less hedging in place will have seen bigger hits to their funding levels, and may be sitting on increased deficits at the moment.

KL: And Rowena, clearly Covid-19 has had a really material impact on many sponsoring employers’ financial strength, and particularly cash position. I’m helping some clients that are facing situations where effectively they have zero revenue, and are looking to apply for government-backed funding, so really serious impacts on the sponsor side.

RM: So Katie, what challenges is this creating for trustees of defined benefit schemes?

KL: I think one of the biggest challenges at the moment is requests from sponsors to defer contributions to pension schemes. Trustees are really wrestling with this question, balancing their duty to ensure members’ benefits are protected, but also trying to support the sponsor through such a challenging time. Trustees are needing to take often uncomfortable decisions which would be very unusual in normal times, and really things are even more tricky where they are in the middle of an actuarial valuation, that they have to do every three years. Getting a clear picture of the impact on the sponsor covenant when there’s just so much uncertainty and flex is a really big challenge that I’m helping a number of clients with at the moment.

RM: OK. And John, what’s been the impact on corporate sponsors?

JD: Yeah, I mean, as we know, many businesses, sponsors of pension schemes, are just fighting hard at the moment to keep their businesses going, and to look after their employees in what are very challenging conditions. I think one challenge for corporate sponsors thinking about their pension schemes is just finding the time at the moment to devote to their pension employee benefits issues. As Katie has said, The Pensions Regulator very helpfully issued guidance in March to help employers and trustees to think about the deferral of contributions to help those sponsors with cashflow issues, and at the moment, we think about 10 percent – maybe a little more – of sponsors have so far taken advantage of these what we call easements.

RM: And David, from a regulator perspective, what challenges are you seeing?

DF: So I recognise a lot of what John and Katie are saying, but just taking a step back, from a funding perspective we’ve seen a really small number of schemes whose funding level has actually improved as we’ve gone through this crisis, but a lot, perhaps as a result of post-2008 experience, as John said, have hedged some of the risks within the pension scheme. And those schemes are coming through this crisis in reasonable shape and might see relatively modest falls in funding levels.

But equally there are some schemes where there was no hedging in place and they may have a mismatched asset liability strategy, where falls in funding levels could be as high as 30 percent. So the challenge for us as a regulator is schemes are coming through this with a real variety of experience. And that’s equally matched by corporate sponsors: some are coming through this crisis relatively well, some are even seeing improvements in profitability, but we have to recognise that this crisis is a real challenge for some organisations. And as John was saying, we’re saying maybe five to 10 percent of schemes being approached by their sponsoring employer to suspend or defer contributions.

From an operational point of view, trustees, administrators, seem to be adapting to these circumstances really well. In the early days, we did have some administrators being challenged by moving to remote working but I’m pleased to say that most now seem to be working well. We are also seeing some challenges to the liquidity in part being driven by the suspension or deferral of deficit contributions, but some schemes seeing an uptick in terms of request for transfer values, and some having challenges around collateral. And really sadly, I’m sad to say that we are seeing an uptick in some scam activity, and it’s really important I think that members’ schemes are aware of the risks there.

RM: Really helpful overview, thanks David. So you just released the Annual Funding Statement (AFS) – can you tell us about how you’re seeking to address these challenges?

DF: Yeah, so we recognise that these are really difficult and challenging times, but as I said, schemes and sponsoring employers are coming through this in many different ways. And that makes it difficult to give generic advice. From a perspective of funding of the schemes, it’s likely that each trustee and sponsoring employer will need to consider the situation in the light of their own particular circumstances. For those schemes and employers coming through this well, we want them to keep focusing on their long-term target and just keep going. As I say, we recognise, particularly if they’ve got a March or April valuation, that it can be really challenging. We do expect that actuarial valuations may be a little deferred compared to normal, so it might be that scheme accounts take time to complete, it may be that investment information is slow to come through, and indeed, individual member data. And during that time, we think there’s an opportunity for the trustees to start thinking about how market conditions could differ depending on how we come out of this lockdown, and how that might have an impact on the assumptions that they use for their valuation.

We expect the sponsoring employer is also looking at a range of scenarios as we come out of lockdown, and also some of the risks that perhaps are threatening their business, and it would be really helpful if employers shared those scenarios so that trustees can think in a very similar way around the scenarios that they need to look at for their scheme.

RM: OK, that’s great, so I think it would be helpful for everyone if we could just go a little bit deeper into the specifics of the AFS. I know John and Katie, you’ve got some questions about it for you David.

JD: Yeah, thanks Rowena. If I take the first one and David, I wanted to kick off with a question about post-valuation experience. The AFS mentions it a number of times and you also talk about how uncertain the current situation is. So what’s TPR saying to trustees? Are you saying take your time because the situation could become clearer in six to 12 months? And I guess the obvious follow-on question from that is, if you don’t mind, how will TPR react to trustees that ask for more time to complete the Tranche 15 evaluations due to this uncertainty?

DF: So to some degree, as I say, there’ll be likely some delay before valuations can start in earnest. But trustees can use that time to think about different scenarios, think about the triggers that they might want to put into recovery plans, to step up contributions over time if they see that profitability and cashflow improve for their sponsor. And they can think about how the scenario develops for their employer, and obviously the longer they wait the clearer the picture might become. But we’re not suggesting that trustees defer for too long. At this stage, we’re not looking to extend the 15 months to complete an evaluation, but we’re obviously keeping that under review.

KL: And David, clearly there will be some trustees for whom post-valuation experience is hugely negative, so for example, those with a valuation as at December 2019, possibly some where post-valuation experience could be positive, so looking at those with March 2020 valuations. Does the regulator expect trustees to factor in experience either way, whether it’s positive or negative? And if only where it’s negative, is there a risk that trustees will be seen to effectively have their cake and eat it by their sponsors?

DF: I think we think because of the particular circumstances that we’re in that post-valuation experience is something that schemes should think about, but whether that post-valuation experience is good or bad, the second principle applies.

KL: Thanks, and linked to that I suppose, given the huge impact on many sponsors, my experience certainly is that getting an accurate view of the covenant at the moment is very challenging – many companies haven’t yet updated their business plans, and even where they try to do that they’re extremely sensitive to assumptions around lockdown ending and a longer-term economic impact of the situation. What does the regulator expect of trustees? Is there an ability to take a bit longer to get a more accurate picture, particularly of the covenant?

DF: So even though business plans may not have been updated, we do anticipate that employers are thinking about how this lockdown is impacting their business, how their business will emerge from lockdown, how quickly they might get back to a new normal, and I guess what a new normal might look like. Clearly, employers will also be thinking of the risk to their business in the short- to medium-term. So we really think it would be helpful for that information to be shared with trustees and perhaps now more than ever, for trustees and sponsors to work together to find a solution that really balances member security with some of the short-term challenges that we’re experiencing. And as you say, it might well be that that picture develops over time, and so it’s really important that the dialogue between employer and trustees continues.

JD: David, thinking about 31^st of March financial conditions, I think the AFS acknowledges that that’s a particularly challenging date to conduct a valuation at, and so it’s going to be difficult for actuaries and trustees to set discount rates at this date. What’s TPR’s expectation here? Some actuaries set their discount rate by reference to models of expected return, and some use the common gilt-plus approach. But I assume that it’s not acceptable for actuaries to say it was gilts plus one at the last valuation so it’s got to be gilts plus one this time?

DF: Well that’s probably important to say, just because it’s difficult setting assumptions, shouldn’t mean that it shouldn’t be done, but to be clear, just rolling forward what was used previously isn’t likely to be appropriate I think. We do expect trustees to work with advisers on different economic outcomes, understand the particular circumstances and impact on the sponsor covenant, and also, trustees could look at a range of scenarios or could work on a preliminary scenario until a clearer picture emerges, and if necessary, we’ll provide more guidance in the autumn on what we think is appropriate.

JD: OK. And you mentioned scenario analysis there, and that feels particularly important at the moment to help trustees and sponsors understand the potential impact of the COVID-19 outbreak on pension schemes, particularly over the longer term. For example, considering how the different shaped economic recoveries could map across to return expectations, interest rates and of course, life expectancy. Large schemes are going to have the resources to conduct the analysis, but small schemes might struggle. What are the regulator’s thoughts here?

DF: So we do recognise that large schemes have got more resource and budget to look at a range of scenarios than smaller schemes, but we do expect advisers to work with trustees to do it in a proportionate and cost-effective way, where it’s a small scheme. It might well be that adviser firms and some of the trade bodies could help in developing some standardised scenarios or thinking around that.

KL: And in terms of scenario analysis, it might be considered even more important than normal to consider the integrated impact of downside risks on the combined scheme and the sponsor, and it’s certainly something that we’re advising our clients on at the moment, but I’d be interested to understand what you see as best practice in relation to integrated risk management at the moment David.

DF: I think that’s right, what you’re doing is obviously good practice, so to some degree best practice is exactly what you’ve just said. But trustees do need to look at the range of scenarios, but they need to look at both the upside and the downside and build into their valuation and recovery plans those scenarios. So looking back, in two to three years’ time, there aren’t any regrets about the decisions that they made at this moment.

JD: Thinking a bit more about recovery plans David, it’s going to be quite hard for trustees and sponsors to agree a recovery plan where affordability is potentially going to be hard to judge, and also where the funding position of the pension scheme could have moved significantly from the date of the valuation. How does TPR envisage that sponsors and trustees might deal with the issue in practice?

DF: We recognise for those schemes that are particularly challenged as we go through this crisis that there are some real challenges, but we think trustees could recognise those difficult circumstances by having contributions that step up over time. Where it’s not possible to do that with a degree of certainty they could agree triggers where contributions increase. As I said at the beginning, some schemes are coming through this crisis well: profitability has improved, and so we may have employers whose business isn’t particularly badly affected by the crisis, and if that’s the case then we do expect them to look at the situation as they would do as normal – we wouldn’t expect them to have easements in terms of contributions that they pay to the scheme.

KL: And as we start to talk about coming out of lockdown, how should trustees be thinking about ending agreements such as contribution deferrals? How do you expect them to protect the scheme’s position?

DF: I think they have to look at the situation as we come out of lockdown, trustees need to carefully monitor changes to the covenant, to profitability, to cashflow, and ensure that the scheme is treated equitably, so if for example, suspended dividends start to be paid, we’d expect any deferral of contributions to be made good and the scheme to be treated equitably going forward.

JD: And David, I’ve not seen this but there have been some suggestions that employers might be gaming the system, so what I mean by that is taking advantage of the current easements on contribution deferral, where they haven’t necessarily been impacted by the COVID-19 outbreak. What’s TPR’s experience of this?

DF: So we do see a really small number of instances where that’s the case. We did see it in the post-2008 financial crisis: some schemes that didn’t really need to take advantage of easements did so. So as I say, it is in a really small number of cases where some employers are looking to put a scheme and member security to a disadvantage. So that’s why in our guidance, we set out the information that should be given to trustees as part of them agreeing to deficit contribution deferral or suspension, and the overall requirement for the scheme to be treated equitably. Where trustees don’t think deferral or suspension is necessary or appropriate, we don’t expect them to push back, and if appropriate they should involve TPR in those discussions.

KL: To a slightly different topic, and in relation to the not-for-profit sector, specialists are predicting that the charity sector could lose over £4.3 billion of income over the next three months because of the COVID-19 pandemic. Clearly that’s at a time when demand for charity services is very likely to rocket. Do you have any specific thoughts or guidance for schemes supported by not-for-profit organisations at this current time?

DF: Yeah, it’s something I recognise personally: I chair the genomics development board for a soft tissue and bone cancer charity, Sarcoma UK, so I see these things absolutely first-hand, but I think our guidance equally applies. It’s important for the trustees of the pensions scheme to work with trustees of the charity, to work out a solution that balances affordability with security of members’ benefits, so I think the same principles apply. Obviously it is really quite challenging because of the nature of charities.

KL: And finally David, how will the regulator be assessing the needs of the market over the next few months? Are you considering issuing more COVID-19 specific guidance in the near future, particularly in relation to the regulatory easements that were set out in the March guidance?

DF: We’ve tried to deal with the most pressing issues and the issues that get raised with us most frequently, so we think we’ve put out the largest proportion of guidance that we need to. But we are constantly monitoring and getting feedback on how the market’s developing, so to the extent that we need to put out further guidance we will do so, but we don’t envisage that it will be at the same frequency and intensity that perhaps we’ve done to date.

RM: So that’s been really helpful, thank you David. I wonder if we just move on now and start thinking about the future, and perhaps the legislative timetable and new DB funding code. David, what will be the regulator’s key priorities over the coming months?

DF: So we’re really focused on savers and protecting pensions, and we'll continue to do that. In the short-term, we’ve recognised that we need to support employers through this crisis, and we’ll do that where appropriate to ensure schemes have profitable and sustainable sponsors who can support them going forward. But we’ve put to one side a number of really important issues, so the funding code consultation for example, the work that we did on trusteeship and governance and in particular diversity and inclusion and climate change and ESG issues, so they’ll all be things that we pick up and drive forward over the coming weeks and months.

RM: OK, and I understand that the initial consultation for the new funding code was extended. How confident are you that this timetable will hold?

DF: So we think the consultation still remains highly relevant. The need for schemes to set a long-term objective and a journey plan on how to get there are still the right things to focus on, and interesting I think schemes that have got really good integrated risk management, addressed issues like sustainable investment risk, and the visibility horizon of covenant are the ones that are coming through this crisis in the best shape. So we still hope to progress to our second consultation and have the code operational by January 2022, and we’re going to work really hard to try and do that. But obviously we need to recognise the uncertainty that exists at the moment, but we are really focused on trying to have this operational as soon as we can do that.

RM: OK. I’d like to move on now to some top tips for trustees and corporates, so what should they be focusing on right now? If I go to David first.

DF: I think trustees are in really difficult circumstances and we need them to do just the best that they can. We need them to appropriately prioritise their actions, what they’re doing, adapt to these new market conditions, understand the risk to the scheme, put in place mitigations wherever they can, and make sure that they’re coming out of this crisis in the best possible shape that they can.

RM: And Katie and John, do you have any top tips that you’d like to add?

KL: I think from a trustee perspective, trustees really need to be thinking about balancing the interests of their members with supporting their sponsor through a very difficult period. I think it’s clear from the annual funding statement that the strong and sustainable employer is in the best interests of members, but for some, taking decisions around that can be a counter-intuitive stance given how they have behaved in the past. But actually that’s essential at the moment, to support the business, and therefore in scheme members’ interests.

The second point I’d make is that learning from past economic shocks, it’s also critical to document the decision process that trustees are going through as the effects of COVID and the EU exit unfold.

JD: Two from me as well. Firstly I’d say that there some interesting opportunities in investment markets due to market dislocations, so trustee boards and sponsors that can be agile are encouraged to review those opportunities. And the same is true of the insurance markets as well, so for better funded schemes that have been considering buy-ins or buy-outs or other types of risk transactions, there’s some interesting pricing at the moment in those markets.

And secondly, I’d encourage sponsors to take a step back and take the time to review their long-term strategy for the pension scheme, and really consider how this needs to adapt to the current situation and also to the new funding regulations that are coming down the track.

RM: Really helpful. Thank you so much David, John and Katie for sharing your insights, and of course thanks to everyone for listening. If you’d like to know more about the themes we discussed in this episode, visit our website at pwc.co.uk/COVID19. We hope you’ll join us next time, and please do subscribe to keep up to date with all of our latest episodes.

Participants

• Rowena Morris, director, PwC
• Katie Lightstone, PwC
• John Dunn, PwC
• David Fairs, Executive Director for Regulatory Policy Analysis, The Pensions Regulator