Cash flow is important but not pressing, experts say

Cash flow has taken centre stage as schemes’ deficits have worsened.

Andrew Warwick-Thompson, executive director at the regulator, said that “the current very low interest rates and reducing expectations for medium/longer-term returns on various asset classes are the key driver of the rising level of deficits”, as well as “rising longevity and financial markets volatility”.

The regulator will encourage schemes to embed risk management in the funding process, rather than it just being a valuation every three years

Sarah Brown, Punter Southall

He said that as “market conditions have changed during the valuation cycle … it is appropriate for trustees and employers to consider whether a recalibration [of contribution levels] is required”.

Warwick Thompson added that the regulator plans to publish a review of the first tranche of schemes to carry out a valuation under the new defined benefit code later this year.

Stop resetting the clock on recovery plans

Jon Hatchett, partner at consultancy Hymans Robertson, said schemes need better funding risk solutions than simply asking a sponsor for more cash.

He recommended matching assets and liabilities and removing investment risks, as well as improving the stability of recovery plans, as schemes change these too often according to Hatchett. “They keep resetting the clock,” he said. 

Hatchett also emphasised the importance of more frequent valuations, especially given the growing availability of technology that allows schemes to conduct them cost-free.

“Many schemes are still only getting into the 21 century” technology-wise, he remarked.

Hatchett said another key issue raised in the statement is the use of the continuous mortality investigation model used to calculate life expectancy. He said it was good the regulator is cautioning schemes “not to use it unthinkingly”. 

“It’s an industry standard but has limitations,” he said, adding he believes it will likely be revised this year or next.

Embed risk management 

Sarah Brown, head of scheme funding research at actuarial consultancy Punter Southall, welcomed the statement’s emphasis on integrating risk management into schemes’ day-to-day practice.

“This will become more central in the future … [the regulator will encourage schemes to] embed risk management in the funding process, rather than it just being a valuation every three years,” she said.

The situation will worsen, since as more schemes are maturing, they will have “no continued contributions” to rely on, and are “in effect becoming net disinvestors”, said Brown.

She also noted the regulator’s tougher stance on late valuation submissions, saying that it needs reliable, up-to-date information for schemes, which is why “it is getting tough on the details”.

Brown said that it will increasingly look closer at whether a tardy scheme should be held accountable, and will be asking if there is a good reason for the delay or if it should intervene. “The regulator is saying: ‘tell us if a delay is foreseeable’.”

Importance of dialogue 

Ben Roach, partner at consultancy Barnett Waddingham, said DB schemes cannot keep relying on deficit contributions as a stop-gap measure for meeting liabilities.

He said the statement was right to highlight cash flow, which has become a bigger issue because of “falling gilt yields … especially combined with a fall in equity markets”, doubling many schemes’ deficits. “Even schemes with LDI in place are still exposed,” he said. 

Roach emphasised the importance of information flow between trustees and employers in mitigating the damage. If an employer isn’t forthcoming with cash flow information, trustees can commission a review; however, this is expensive for trustees and troublesome for employers, so communication is prioritised by both parties.

Roach said the regulator was right to emphasise that trustees should “properly value the cost of future benefits accrual”.

“The cost of accrual has gone up; schemes should question whether to reduce that accordingly,” he said.

Increase illiquid investments

Alex Koriath, head of UK pension practice at investment consultancy Cambridge Associates, pointed to the regulator’s warning about low returns on traditional asset classes in recommending illiquid assets as a good alternative.

“Illiquid investment opens up opportunities you won’t have from the public market alone,” he said, adding that such investments are also “quite cash-flow generative”, which should be of importance to deficit-laden schemes.

“If you want to reduce volatility and risk, don’t pull down returns further by not balancing your portfolio,” Koriath advised, adding that investment premiums should be captured more effectively. “Generate some returns to close this deficit,” he urged. 

Koriath said if a company planned on yields going up, it has to “put a stronger plan in place … because [otherwise] this is a hope-based investment”.