Mercer's Le Roy van Zyl looks at the levers available to scheme and employers in the regulatory funding regime and how they can be used to deliver security and affordability.
The regulatory scheme funding regime provides some parameters in which to achieve a solution, but there is substantial flexibility to achieve one that is scheme-specific, a fundamental regulatory requirement.
Action points
Assess whether the covenant can really afford current risk levels
Work through 'what if' scenarios and consider the impact on one another
Work jointly to set up a contingent risk management framework
The security and affordability requirements are far from mutually exclusive. Efficient answers are very much about using the full range of levers available to trustees and sponsors.
What is prudence?
The regulatory and fiduciary need to manage a pension scheme in a prudent manner is underpinned by trust law. The longstanding approach that has historically been adopted for prudence is to focus on prudent valuation assumptions.
This does not fully meet the benefit security requirement and such a narrow focus poses a significant risk of worsening member security.
Take, for example, the simple situation where the outcome of a valuation is for the sponsor to pay the affordable contributions based on the trustees’ covenant assessment, using a prudent set of valuation assumptions.
A key question remains, however, around the ability of the sponsor to pay even more contributions if the assets subsequently underperform the liabilities.
If the current deficit is just being covered by affordable contributions, then the additional deficit will presumably be 'unaffordable' and may well damage the covenant?
It is very important that the role and affordability of investment risk is for example also fully brought into account.
An integrated approach
The Pensions Regulator in its latest consultation has again stressed the importance of looking at scheme funding within the context of the risk being taken and the support available from the sponsor.
In a nutshell, the golden rule is that the sponsor must be able to not only finance the current pension scheme deficit over time, but also the extent to which it may worsen if the risk being taken does not pay off.
The new guidance should also reflect the objective around “minimising the adverse impact on the sustainable growth of employers”.
The direction of travel within the new guidance is useful, albeit we do not believe it goes far enough. In relation to risk and security, it demonstrates the following:
Strengthening the covenant enables risk to be taken to help finance benefits and support sustainable growth;
Taking investment risk is seldom a solution where contribution affordability is already constrained;
Covenant strength is not just about the here and now, but also about how long it can be relied upon, and how it may correlate with funding setbacks.
One of the most common inefficiencies is an excess or inappropriate level of investment risk with the aim of achieving a very low risk position in future, effectively assuming their covenant is likely to become almost non-existent at that time – an unrealistic assumption for the vast majority of sponsors.
Clearly, if conditions permit and a scheme is able to reach such a very low risk position opportunistically, member security will be very good, but care is needed that this objective is not prioritised over others, including ending up with potentially unaffordable risky strategies to get there, or having an adverse impact on the very covenant that will support the scheme in the long term.
Contingent events
The regulatory regime is increasingly focused on the need to allow for greater mitigation of certain contingent events.
The normal triennial valuation is an example of an action that may help alleviate any future financial pressure on a pension scheme.
But in certain respects, the traditional approach is vulnerable to adverse outcomes precisely because it is subject to negotiation.
Should the next three years turn out to be financially poor, the sponsor’s position may also have deteriorated making it unwilling or unable to pay additional contributions.
A more robust framework can be created by agreeing in advance that certain financial remedies will be made should conditions worsen beyond a predefined point.
A balance should of course be struck so such actions do not worsen the covenant in itself.
Le Roy van Zyl is a principal in Mercer’s financial strategy group
