RECENT press has suggested that the revised guide issued by The Pensions Regulator (TPR) to trustees and scheme sponsors, while worthy in itself, is being widely ignored by finance directors, many of whom have yet to open their copy of the 50-page guide.
The guide is particularly important since it introduces in a very clear way the Pensions Regulator’s view that there is a role for risk in the management of a pension scheme, yet just 43% of employers have read at least part of the publication, according to a survey by the regulator.
It is intended to help all parties take a more collaborative approach to funding negotiations and, while 84% of trustees were familiar with the code of practice, only two in three employers knew what it was.
“The regulator has made it clear that it wants trustees and the sponsoring company to work together to ensure that – where they are consciously taking on risk – it is a risk that they can manage,” says Charles Cowling, a director at JLT, one of the world’s largest insurance brokers outside the US.
Although the overhauled code, which introduced a statutory objective to minimise the adverse impact of funding plans on the sustainable growth of the employer, came into effect last year, the watchdog still had work to do to improve awareness among employers.
“The new code encourages a collaborative working process between trustees and employers and it is vital that employers, as well as trustees, understand the complex relationship between funding, investment and covenant,” says Barnett Waddingham head of corporate consulting Nick Griggs.
“As we head into 2015’s valuations, low gilt yields are going to cause further pressures on pension schemes. Employers should get ready for some tough negotiations and reading the regulator’s guidance will give them a good grounding in the trustees’ expectations, as well as those of the regulator.”
Cowling heads up the JLT’s advisory service on the management of pension liabilities and points out that the guide sets out three clear principles for trustees and sponsoring companies. First, that trustees and the sponsoring company should work jointly; second, that they need to establish what risks there are in the portfolio; and third, that they need to form a view on the appropriateness of the risk that is being taken as opposed to the state of the scheme and the financial strength of the employer.
This is not a new move. The Pensions Regulator has always taken the view that trustees should not be discouraged from taking risks that they feel they can manage. But this is much more codified and thought through, as guidance, in the latest code of practice than has been the case in the past, he says. “There is a whole section on the integrated approach to risk management. The aim is not to eliminate risk completely from scheme funding, but to understand it and to manage it appropriately,” he says.
In this regard, Cowling points out that one simple piece of advice for trustees is to use the LDI (liquidity-driven investment) approach as the basic benchmark and starting point for evaluating other asset allocation strategies. “The plain fact is that LDI funds that matched pension liabilities were the best-performing asset class by a country mile in 2014. Long-dated bonds outperformed spectacularly. LDI is the least risky position for any pension portfolio so trustees need to measure the risk they plan to take by investing in a different asset class and see if that risk is worth taking relative to an LDI fund,” he says.
Since the price of long-dated bonds goes up as the yield goes down, this era of ultra-low yields has made bonds perform exceptionally. Cowling notes that it is difficult to see further upside in this direction since interest rates are already at rock bottom.
However, with the Swiss Central Bank introducing negative rates, zero is no longer the theoretical bottom for rates and bonds could continue to outperform. While the US Federal Reserve is trying to exit its quantitative easing programme, there is no certainty that it will be able to raise rates in the next 12 months, and the European Central Bank and the Bank of Japan are both thoroughly committed to QE for the foreseeable future. No doubt this makes it a complicated world for trustees and their advisers, but it does also mean that LDI is likely to continue to be both a low-risk and very attractive option for a long time to come.
Cowling reckons that the Pensions Regulator’s survey, which showed that finance directors have yet to get to grips with the guide, should not be taken to mean that they are not taking it seriously.
“You have to remember that finance directors are most engaged during the tri-annual valuation of their company’s pension fund, when funding strategies have to be reformulated. The guide only came out last July. Many are still a long way from their funding discussions and will get to the guide in due course. I would be more worried if there was evidence that trustees were ignoring the guide, but in our experience that is not happening,” he says.
Finance directors, of course, can rely on their advisers to tell them what to do. What their advisers will be telling them is that the guide helps finance directors by introducing more flexibility into the funding process.
“The government announced in the Budget that it wants to introduce a new requirement on the Pensions Regulator that trustees should have regard to the growth prospects of the employer in determining the funding of a pension scheme. This has been taken up by employer groups which argue that trustees need to be aware that demanding extra money for their scheme can have a negative outcome on employers. The guide supports the idea that trustees need to seek a funding outcome that reflects a reasonable, balanced attitude to risk. Unfortunately, as liabilities increase – which they are bound to do in a low-interest rate (and therefore a low-discount rate) environment – the risks on the balance sheet also start to look bigger,” he adds.
Deloitte partner Andrew Power says that one of the reasons why some finance directors in large companies have not yet got around to the new guide is that larger companies have been fully occupied dealing with the requirements of auto-enrolment.
“There are always going to be tensions between the viewpoints of trustees and directors because they represent different communities of interests, and those interests can sometimes point in opposing directions,” he notes. In his view, the new code simply provides a good level of guidance on things that the better-managed companies are already doing.
“It definitely puts trustees more on the same page as finance directors. The latter will want outcomes that lower their company’s contributions to any shortfall in funding and, in the long term, this rapprochement between trustees and finance directors could be beneficial,” he adds. This is because accounting conventions, allied to all the risks in the market, were making trustees very risk averse, up until the new guide was issued.
“The unusual concatenation of risks in the market includes a whole bunch of unforeseen macro-economic risks caused by factors such as the rise of IS and the annexation of Crimea by Russia, along with the separatist conflict in Ukraine. The guide probably introduces a way of balancing things out to where they were before the financial crisis. But the bottom line is that companies are still finding it extremely difficult to deal with the growing longevity and interest rate risks to their schemes, and are finding it very hard to make defined benefit pensions work.
This is a problem, particularly as the government is trying to withdraw more and more from state funding and everything is falling back onto the individual to look to support themselves in their old age – something that few are equipped to do when you look at the pressures on household incomes,” he says.
First among equals
Tony Hobman, who has himself been the Pensions Regulator from 2005 to 2010, is now chairman of the advisory board at Lincoln Pensions, which specialises in advising trustees on the strength of the employer covenant standing behind the scheme. He reckons that the guide is a significant improvement on the earlier guide, particularly because it puts the strength of the employer covenant as “first among equals” (his words) among the three risks trustees need to consider. The other two are investment risk and the scheme-funding risk, which is all about the scheme’s ability to meet its obligations.
“Covenants and the funding of them have always been an important part of the funding equation, but the approach to evaluating covenant strength has not always been done in a structured way. Employers and trustees will have discussed funding and investment issues at some length but rarely will they have a real grasp of the status of the employer’s covenant,” he comments.
So how open are companies to having their figures scrutinised by an outside party with a brief to evaluate the covenant? “It varies,” Hobman says. “Usually, getting the right non-disclosure and confidentiality agreements in place will settle concerns, but sometimes employers might be more wary of the process. However, the employer has an interest in making the right information available so that an agreement can be reached with the trustees.” Both sides will find the latest guidance helpful in that it does direct them to consider the strength of the covenant. ?