What to consider when agreeing a recovery plan in 2019

On the one hand, a longer recovery plan increases the period over which the scheme relies on the covenant and implies increasing risk for members. On the other, trustees should have due regard to the competing funding needs of the sponsor’s operations and growth aspirations.

We have seen a number of instances where the watchdog has challenged the assumption that strong covenants can be used to justify longer recovery plans and reduced funding

The Pensions Regulator’s existing guidance advises trustees to “eliminate any deficit over an appropriate period, taking into account scheme and employer circumstances”.

The latest available statistics show that the average recovery plan length for UK schemes is approximately eight years. Where recovery plans are longer, this tends to be associated with schemes with weaker covenant support, higher allocations to return-seeking assets and larger technical provisions deficits.

How have recovery plans been agreed in practice?

Until now, the focus for trustees has been on being able to demonstrate that a negotiated recovery plan sufficiently protects the interests of their scheme’s members.

A key factor has been the covenant strength of the sponsor; in cases where the covenant has been stronger (meaning the sponsor is more likely to be able to underwrite pension scheme risks), cash funding has sometimes been reduced through longer recovery plans and a greater reliance on investment returns.

In addition, affordability of contributions has been assessed by trustees while taking into account the competing requirements for meeting operational needs and/or growth aspirations of the sponsor (ie its plans for sustainable growth).

Finally, some trustees have been able to obtain contingent assets for their scheme as a basis for reducing the level of contributions to the scheme. These factors have combined to result in recovery plans being longer than they otherwise might have been.

Regulatory landscape is evolving

Trustees looking to agree a recovery plan in 2019 may face a somewhat different – and evolving – regulatory landscape to their last valuation.

For instance, the regulator’s annual funding statement in 2018 put particular emphasis on the need for stakeholder equitability, meaning that where dividends are disproportionate to deficit repair contributions, a shorter recovery plan is expected.

In addition, a new defined benefit funding code of practice is expected to be introduced in 2019 by the Pensions Regulator on the back of the Department for Work and Pensions’ 2018 white paper.

Within the industry, it is widely expected that trustees will be required to set a long-term funding target and communicate a detailed and robust plan for how it will be achieved.

We have also seen a number of instances where the watchdog has challenged the assumption that strong covenants can be used to justify longer recovery plans and reduced funding.

Instead, the regulator has argued that stronger covenants are able to and, by extension, should remove deficits sooner, thereby reducing reliance on investment returns.

Although a new code of practice will not be in place until later in the year, it will still be important for trustees to take account of its requirements for valuations ongoing at the time of its issuance.

As a result, we expect three key considerations for trustees agreeing recovery plans in 2019:

1. Decide the long-term funding objective for the scheme and develop a strategy to reach it based on the covenant’s ability to support investment, demographic and other risks (eg guaranteed minimum pensions). Look to set the technical provisions and the associated recovery plan in the context of the established end game.

2. Be aware that longer recovery plans today, especially in the context of sponsors paying significant dividends, might be questioned in the future, particularly if subsequent covenant deterioration places members’ benefits at risk.

3. Focus on protecting the scheme from downside events impacting the sponsor through augmenting the covenant with contingent assets where possible, and develop actionable contingency plans that protect the scheme if the covenant deteriorates.

Matt Harrison is a managing director at Lincoln Pensions