What do LTFTs mean for sponsors of defined benefit pension schemes?

In its 2019 Annual Funding Statement released in March, the Pensions Regulator (TPR) announced an expectation that trustees and sponsors of all UK defined benefit pension schemes should agree a Long-Term Funding Target (LTFT).

Although not yet a legal requirement, it is a clear sign that TPR wants to end the current funding regime based on, often-misleading, “technical provisions” which do little to protect members over the long term. Whilst many trustees have already begun to think about what this can mean for their scheme, our experience is that few sponsors have begun to address the significant implications this may have for their financial performance, risk budgets, and investors.

Setting a LTFT will require trustees and sponsors to agree a proposed solution to their legacy pension liabilities – based on current market practices. This will be a choice between buying out the scheme’s liabilities with an insurance provider, or funding and administering the scheme on a low-risk basis (often referred to as “self-sufficiency”). Other alternatives may become available in the future, such as transferring to a pension scheme consolidator, or reducing benefits where full funding is not realistic.

In all cases, once the LTFT has been agreed alongside a timeframe to reach it, trustees and sponsors will need to agree a balance between funding and target investment returns. This should follow an Integrated Risk Management approach whereby pension risks are taken based on the ability, and willingness, of the employer to support them (i.e. the employer covenant).

Until now, if a scheme’s funding level has not improved as expected, trustees and sponsors have often allowed more time for further contributions and investment returns, which caused recovery plans to become longer. But, in this new regulatory environment, it is now expected that sponsors will increase higher contributions to get their schemes ‘back on track’ more quickly if a scheme’s downside risks crystallise.

Changing tack

Kicking the can down the road will no longer be an option, especially as schemes become more mature, and pension risks will start to have near-term impacts on their sponsors.

Whilst much focus has been on what LTFTs mean for trustees, as important is the impact on the sponsor’s risk journey. So, what do sponsors need to do differently?

First, sponsors need to manage pension scheme risks alongside the others in the business. If sponsors choose to take more risk in their pension scheme, then sponsors must develop contingency plans for what they will do if increased funding is required in the future as a result, and consider whether this would be acceptable given the impacts on their other business objectives – such as to invest in growth or to reward investors.

Ultimately, this will require sponsors to allocate a portion of their total risk budget to their pension scheme, and to monitor and adjust this allocation over time as competing pressures arise in the business, just as they would for other business risks.

Secondly, sponsors will need to take greater interest in the investment decisions taken by the trustees of their scheme. As the sponsor must face the consequences of the risks which are taken, it is essential that the investment strategy is consistent with its objectives, and that trustees and advisors are held accountable for the outcomes.

For instance, the traditional quarterly trustee meeting is unlikely to provide a sufficiently robust governance framework for decision-making, and sponsors should push trustees to delegate investment decisions to a flexible and knowledgeable sub-committee which includes sponsor representatives. Alternatively, a fiduciary manager could be appointed to handle day-to-day investment decisions and to improve the likelihood of a rapid response to emerging risks.

Thirdly, sponsors must improve transparency over the size of pension funding requirements and risks. This will typically mean going beyond mandatory accounting disclosures to include i) a measure of the scheme’s deficit on a “low-risk” basis, ii) details of all current funding requirements, and iii) a measure of investment risk.

By doing this, investors and analysts will better appreciate the management team’s resource-allocation decisions, and are less likely to be surprised by the actions that the management team will need to take if the investment strategy does not deliver the desired results. Without this additional disclosure, it could be argued that directors are not presenting a “true and fair” view of the sponsor’s financial position.

Finally, with pressure to increase funding comes increased risk that pension schemes could become overfunded. Even where it may be possible to return surpluses to sponsors (which is not always the case) this would still represent an inefficient deployment of capital in the business.

Therefore, sponsors should be proactively taking steps to manage the risk of overfunding their schemes whilst still providing the additional support which is required. This could include making use of reservoir trusts to make it easier to return surplus funding to sponsors or providing contingent assets, such as letters of credit, rather than increased funding.

Such arrangements are becoming increasingly common in the pensions landscape and are recognised by TPR as reducing the risks to pension scheme members without placing excessive funding demands on the sponsor.

Overall, it’s clear that sponsors will be expected to directly bear their pension scheme risks, so they must make a concerted effort now to manage them. As a minimum, we recommend that sponsors:

1. Be prepared to disclose the size of the ‘real’ pension risks to stakeholders to avoid surprising them in the future – they will soon be asking for this information anyway;
2. Engage with trustees concerning the investment decisions, and ensure the risks they are taking are ones the sponsor is able, and willing, to bear; and
3. Explore the use of alternative security structures to reduce the risk of overfunding the scheme and inefficient use of the business’ capital.

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