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Mitigating the funding plans and pensions accounting impacts of Brexit

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In the second of three articles looking at the impact of Brexit on defined benefit pension schemes, this blog looks at how trustees and sponsors can take action to mitigate the risk of their funding plans and pensions accounting results being blown off course.

The truth is that each scheme’s reaction to Brexit must be scheme-specific. Research by The Pensions Regulator showed that around three in four schemes were in deficit, with one in four in surplus. Covenants range from strong to in-distress across all sectors. Some schemes take a lot of investment risk, others have locked down risk. Hedge ratios differ. All of this must be considered when deciding how to tackle Brexit.

The Pensions Regulator’s view of the scheme is critical too. The Regulator has provided a range of views on funding and risk since the financial crisis. However, it is clear to all now that the Regulator is toughening its stance. Even where the covenant is strong, higher contributions and/or shorter recovery plans are being called for. The Regulator has also been using its powers for the very first-time.

In terms of the immediate task of Brexit, the Regulator expects trustees to assess the outlook for the economy—which is not looking good as I write—and the relevant sector of the sponsor. Where there are material concerns, sponsors are expected to explain the potential impact of Brexit on the balance sheet and cash-flows. Indeed, many of our own trustee clients have written to their sponsoring employers asking about the impact on their business.

As you might expect, the starting point should be to review the scheme’s integrated risk management framework. Most pension schemes should already have a broad framework in place. This will look at the covenant, funding and investment risks. However, a more, dare I say, integrated approach may be beneficial in understanding the impact of Brexit.

An example always helps. While falling gilt yields may result in higher deficits, a Brexit outcome that leads to falling yields can reduce the cost of borrowing for a sponsor and therefore improve the covenant. In these circumstances, the overall security of members’ benefits may be unchanged, or even improved – though that seems likely to be the rare exception.

From a funding perspective, changes in long-term interest rates and long-term inflation expectations from Brexit will be key to how funding plans are affected. Trustees and sponsors should consider how moves in either direction will impact on investment portfolios and covenant, as well as the funding position. Once schemes understand the main risks and their probability of occurrence, they can take informed decisions to mitigate them.

Let us look at a few scenarios that DB schemes may find themselves in now. I will start with the most distressed situation where there is a significant scheme deficit, the recovery plan is long, there is a lack of affordability and significant risk exposure to movements in interest rates and/or inflation. This combination could significantly impair the security of members’ benefits overall. In truth, the funding options available are unlikely to resolve the problem quickly enough. A more effective strategy in this situation maybe to significantly de-risk the investment strategy to lock down risk. While locking down risk is good, it will decrease discount rates within the funding model and therefore, all else being equal, increase demands for cash. Of course, this could be the wrong time to ask the sponsor for more cash and so needs to be carefully considered to avoid damaging the sponsoring business irrevocably.

A more common scenario that schemes find themselves in is where there was a deficit at the last valuation a year or two ago, with an agreed recovery plan that aimed to clear the deficit over a five to ten-year period. For those where (a) the covenant continues to be strong or tending to strong and (b) exposure to deterioration through Brexit is limited, it could be that the trustees are comfortable to defer any decision to act until the next actuarial valuation. Even where this is the case, we have seen many of our clients increasing the frequency of covenant reporting, including regular updates on how Brexit plans are developing. Indeed, some have created a reporting dashboard of key performance metrics, which is reviewed at each quarterly meeting.

For those with a deficit, a funding plan that is now behind target and a covenant that is either weaker or is more exposed to the worst-case Brexit scenarios, we are seeing some clients entering into dialogue with the sponsor on improving the security of members’ benefits. In this situation, the Scheme Actuary must recertify the improved funding plan to avoid the need to call a costly early valuation. Recertification becomes more difficult with the length of time since the last valuation. Where that period is deemed ‘long’, for example where the last valuation was in 2017, I would expect a new actuarial valuation to be needed.

Despite the above, the formula for dealing with Brexit does not have to be:

Increasing deficits + More uncertainty = Far higher contributions from the sponsor
 

For anyone carrying out a formal valuation now, there is no doubt going to be pressure to increase contributions. However, in many circumstances, modest increases of cash into the scheme can be supplemented by improved non-cash security. Examples we have seen include:

  • More valuable guarantees from stronger parent companies, ideally whose outlook is less sensitive to the outcome of Brexit;
  • Increases in the guaranteed obligations, from covering the remaining contributions in the recovery plan to meeting the full buyout deficit should the UK company fail;
  • Sponsors being happy to offer profit-sharing arrangements, which pay contributions into a scheme where certain pre-agreed profit levels are achieved; or
  • Downside risk mechanisms that improve security—be it through contributions or non-cash security like contingent assets—if funding levels deteriorate in future.

I have talked a lot about the funding risks of Brexit and how to mitigate them. However, spare a thought for DB sponsors. They must disclose their DB obligations in their accounts. With yields on corporate bonds also at very low levels, pension impacts on balance sheets and income statements are likely to worsen over the year.

While some of the actuarial assumptions that are used for pensions accounting are prescribed, there are flexibilities available when deriving discount rates, inflation and mortality assumptions. These can help offset some of the expected bad news. For example, there is some room to manoeuvre over which basket of corporate bonds to use when determining the yield curve used to discount future cashflows. Furthermore, the Office of National Statistics plans to change the formulae underlying RPI inflation to align with those underlying CPIH inflation. This is expected no later than 2030. This provides an opportunity to discuss with auditors whether an early move to CPIH is appropriate.

Of course, liability management in the form of either a pension increase exchange or enhanced transfer value exercise can produce balance sheet and income statement savings.

In summary, the recent fall in gilt yields, increased regulatory pressure, and the uncertainty of Brexit could blow funding plans and accounting results off course. But there are levers schemes can use, whatever the circumstances, to plot a course through the short to medium term difficulties while we all wait for the political and economic situation to resolve.

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