Southern Water agrees higher DRCs after regulator investigation

The watchdog took action over what it felt was an imbalance between the funds contributed to the Southern Water Pension Scheme and the level of dividends paid to shareholders in 2016 and 2017.

The more that the regulator can tell us what their thinking is, the better

Rosalind Connor, Arc Pensions Law

As a result, Southern Water will pay £50m more into the pension fund over a shorter recovery plan period. Initial payments will be up to twice as much as before, with every subsequent payment also higher.

Recovery period too long

In a recently published regulatory intervention report, the regulator said it was concerned about the “unnecessary risk exposure” because of the inappropriately long recovery period, given the strength of the company.

In December 2015, the trustee and Southern Water agreed a valuation as at March 31 2013, which according to the regulator did not comply with funding legislation.

Discretionary dividends were materially higher than deficit repair contributions, which the regulator believed represented unfair treatment of the scheme.

However, Southern Water and trustees of the scheme, which has nearly 4,000 members and a deficit of around £252m, said the 2013 valuation was compliant.

The investigation started when the scheme’s 2010 valuation was more than nine months late, leading the regulator to investigate further. The recovery period was 15 years long, but the regulator said the employer could afford to pay more and reduce the level of risk in the scheme with a shorter recovery period.

Despite the regulator explaining its concerns on the 2013 valuation with the trustee and Southern Water, the company decided to declare dividends of around £210m from 2015 to 2020, and in 2016 and 2017 the company paid dividends of £190m to its investors. These were the first dividends in more than five years.

Watchdog issues warning

Under the 2013 valuation agreement, DRCs were to be effectively halved from £20m to £10m a year over the period 2016 to 2019, despite an increase in the pension fund’s deficit.

“Despite our clear warning that the proposed [recovery plan] would, in our view, be non-compliant with funding legislation, both parties agreed the 2013 valuation and submitted it (nearly 18 months late) in December 2015,” the watchdog stated in its report.

It began regulatory proceedings in relation to the 2013 valuation, issuing a warning notice under section 231 of the Pensions Act 2004 in June 2017 in connection with that valuation and the recovery plan in particular.

Trustees reporting a failure to agree the 2016 valuation led to the watchdog preparing a fresh warning notice to be issued in Spring this year, although the trustee and Southern Water ultimately reached an agreement in time to head off formal regulatory action.

The agreement strengthened the technical provisions assumptions. It also significantly increased DRCs, which resulted in a recovery period ending in 2029, one year before the 2013 recovery period, despite the deficit revealed by the 2016 valuation being larger than that revealed by the 2013 valuation.

It included additional contributions to cover £30m of the increase in the deficit arising after the 2016 valuation date, known as post-valuation experience.

The agreement also introduced a dividend sharing mechanism to ensure the scheme would be treated fairly.

A spokesman for Southern Water said: “Given the increased pension deficit we have agreed to increase contributions to ensure that members' interests continue to be our priority. In addition, our shareholders (who are mainly themselves pension funds) have supported the introduction of a sharing mechanism such that deficit repair contributions will increase with dividends.”

Regulator more vocal

Rosalind Connor, partner at Arc Pensions Law, said the report can be seen as useful guidance for schemes. “The more that the regulator can tell us what their thinking is, the better,” she said.

Connor said high-profile collapses and select committee scrutiny mean the regulator may feel under some pressure to highlight successes in its investigations or regulatory action.

“They were very keen in the early years not to tell the outside world whether they’ve got people to change their approach, because the perception was that if you didn’t broadcast it, you were more likely to get people to work alongside you if they were comfortable it wasn’t going to go out into the public domain,” said Connor.

In its report, the regulator has laid down definitive markers for the length of recovery plans, which its statistics show are 5.9 years on average for strong employers and 7.2 years for “tending to strong” employers. “We are likely to have concerns where RPs for strong employers extend beyond this,” the watchdog said.

Martin Hunter, principal at XPS Pensions, emphasised the importance of assessing the employer covenant: “The first step in a valuation process – and a critical step – is that covenant assessment… and also looking at the question of affordability."

"A key aspect of that analysis will be looking at the dividend payments, or any other payments going out to other stakeholders in the business. That has been a big focus of the regulator in the last few years and I expect that to continue to be the case in the years ahead,” he added.