Taking control of your pension scheme’s future
Our four-part guide will give you insight into how you can form a coherent strategic plan tailored to your unique circumstances.
Read Part 1 today and look out for parts 2, 3 and 4 over the next 3 months.
The Pensions Regulator (TPR) has raised the bar and now expects all pension schemes to set a Long Term Funding Target and document their journey plan to get there. But what does this mean exactly and how can a scheme go about fulfilling these requirements?
At XPS we believe a successful journey plan is more than a de-risking flightpath. It should capture all strategic decisions and culminate in a clear action plan to get your scheme from where it is today to its end-game.
In this four-part series we have grouped the various considerations into four key areas of strategic decision-making, highlighting the main issues that need to be considered and acted upon by all DB pension schemes.
Together this represents an Integrated Risk Management approach.
Part 1 | Understanding your Sponsor
Why understanding your sponsor is crucial:
− Every DB scheme is reliant on the support from its sponsor to some extent
− The sponsor has to fund any shortfall and it underwrites all the risks the scheme is exposed to
− The Pensions Regulator expects trustees to understand the strength of the covenant and categorise their scheme accordingly
− Decisions made based on the covenant now will influence the scheme’s future financial position
What action you can take:
− Take steps to understand your current risk tolerance
− Build this assessment into investment and funding strategies
− Set a plan to preserve and improve security either immediately or over time
− Monitor the covenant regularly and act promptly if needed
− Be vigilant for any covenant leakage and be ready to protect the scheme
The Pensions Regulator (TPR) now expects trustees and employers to develop a Long Term Funding Target (LTFT) for their schemes (beyond becoming fully funded on the technical provisions basis) and to put in place a journey plan to achieve that target reflecting the strength of the employer covenant. The wider framework mapped out by TPR for balancing key risks faced by pension schemes is built on a new categorisation of schemes determined by several key characteristics.
Which Regulator category applies to your scheme?
Step 1: Determine your letter
Step 2: Determine your number
1. Immature scheme (fewer pensioners).
2. Mature scheme (more pensioners).
Trustees will need to have a solid understanding of the employer covenant characteristics of their scheme. This will be important to determine in which category their scheme fits in TPR’s new framework and more importantly what expected actions follow from that.
5 key covenant questions that trustees should be able to answer
1. How much can the company “comfortably afford” to pay in ongoing annual cash contributions?
− This is the amount that the company could, if required, pay out in cash on an annual basis without undermining day to day operations, capital expenditure, future business growth opportunities and a reasonable dividend policy.
− This is a key input when it comes to cash funding negotiations and understanding the desired long-term risk tolerance of the scheme. It is an essential input in the process of setting the Long Term Funding Target – which will be covered in detail in Parts 2 and 3.
2. What is the “upper threshold” in terms of annual cash affordability?
− This is the upper limit that the company could pay out in cash on an annual basis without pushing the company into insolvency, it is likely to compromise future growth opportunities and have material implications for other stakeholders including dividend policy.
− This will inform the maximum level of risk that can be taken in the journey to get to the Long Term Funding Target, which will be covered in part 3.
3. How might affordability change in the future?
− This includes understanding the company’s prospects and the uncertainties surrounding this, which will be a combined picture of factors specific to the business, the wider industry, sector, geographic and political environment.
− This ultimately affects both the comfortable level and upper threshold of cash affordability in the future. It therefore affects the choice of long-term target and the amount of risk that can be taken on the journey to get there.
4. What is the existing level of security?
− This includes understanding the strict legal recourse of the scheme in an insolvency event based on the corporate structure, borrowing arrangements and security provisions as well as the balance sheet of the sponsor.
− Understanding this element highlights the key factors that are of greatest relevance to the scheme’s security and how this security can be positively and negatively impacted by corporate actions.
5. What options are available to improve the security of members’ benefits?
− There are often ways that a scheme’s security can be improved either immediately or over time.
− By having a clear understanding of the current position and available options, the scheme can set on a path to preserve or indeed improve security over time.
Assessing covenant strength in practice
The covenant strength will be determined by a host of factors, including:
Developing a good robust understanding of all these areas and bringing them together to form an objective view about the covenant strength can be challenging. The following case studies illustrate how conclusions can hinge on small but significant details:
Balancing needs of different stakeholders
Sponsor free cash flow can be directed to a number of places:
TPR has reiterated its concerns regarding the relatively high level of dividend payments compared to pension contributions and the recent divergence between these. Trustees need to ensure an equitable treatment of the scheme relative to other stakeholders and restore the balance if needed. Similarly, any material leakage of value from the covenant net should not go unnoticed and these may need rectification in the form of mitigation. In relation to these issues trustees are expected to become more active stakeholders.
How to manage the employer covenant
Trustees often have more scope than they realise to manage the risks to which their scheme is exposed. Specifically they can:
Maintain a collaborative relationship with the sponsor
Be an active stakeholder, not afraid of asking difficult questions
Understand the level of risk the sponsor can underwrite and manage the scheme within this
Seek contingent assets and non-cash support
Be alert to covenant leakage and ensure fair treatment of the scheme
Monitor the covenant regularly and consider the impact of one-off events
Review the journey plan in light of the changing covenant and realign it if needed