The beginning of the DB endgame

We are still in the foothills of the defined benefit funding mountain and the flexibilities in the new funding Code may be clouding the view of the summit says Lincoln Pensions CEO Darren Redmayne

Over the past 12 months there has been a developing sense that the funding issues of defined-benefit schemes are largely behind us. With a recovering economy, things seem ‘back on track’ with improving sponsor covenant and improved investment performance.  Indeed, as a covenant practitioner, we’ve even seen a few sponsors raise concerns about having trapped pension surpluses again – quite different to 2009.

After a difficult few years, confidence has been building among corporate sponsors. This has led to improving financial performance which is welcome relief for all and, in a number of cases, an increased ability to afford higher pensions deficit contributions. As a result, some Trustees have formed the view that this better environment should have led the covenant of their sponsors to improve. However, this isn’t necessarily the case.

Too often, covenant is wrongly equated to be the operating financial performance of a business without relating it to the risk of the scheme the sponsor is standing behind. Consequently, a number of schemes that consider they are monitoring covenant are actually monitoring financial performance which is only part of the exercise. This goes to show that covenant risk remains, of the three fundamental areas of risk highlighted by the Pensions Regulator in its guidance, perhaps the least well understood.

What has happened since the financial crisis is that, relatively speaking, the operating financial environment has indeed eased. However, following three rounds of quantitative easing and greater volatility in the investment markets, the overall risks within defined-benefit schemes have dramatically increased over the same period. The combined effect has been, in many cases, that financial performance has improved, but the sponsor covenant has weakened. 

Most people working with defined benefit schemes are familiar with the so-called ‘armadillo shape’ that represents annual cash outflows as a plan matures. Currently, most schemes are at the nose end of this shape, with the peak outflows coming in 15 to 20 years, as people retire and draw their pension, and then, depending on the scheme and how longevity actually plays out, there is a lengthy tail which can run in excess of 30 years.

Schemes have therefore around 10 to 15 years from now to deliver an investment and funding strategy which will ensure that they can ride out the armadillo shape when peak outflows crystallise.  There is still time, but as each year passes the period for any investment strategy to work will become shorter and a greater reliance will be placed on the sponsor covenant to fund a shortfall.

Enter now the new defined benefit funding Code published by the Pensions Regulator in July, which provides the possibility of potential flexibilities to sponsors. Sponsors can, provided trustees are comfortable with the risks, ask to reduce contributions on the basis that the sponsor will cover investment shortfalls at a later stage and money is perhaps better invested in developing the sponsor than the scheme. 

So we have a situation where companies have a greater ability to afford pensions deficit contributions than during the downturn when contributions were arguably set at a low level to support sponsors; sponsors are often considering maintaining contributions where they were during the downturn and running higher investment and funding risk given the flexibilities in the new Code; and trustees need to respond in line with the new Code to take properly informed decisions on whether these risks are acceptable.

Much has been written about the increased flexibilities and the pendulum is swinging back in favour of the sponsor. Undue focus on this flexibility has the potential to cloud the view of the shared challenge of taking a balanced approach to scheme funding. In particular, if higher risks are run and things don’t go to plan, the strain on the sponsor will be greater when the time left before the peak in the armadillo is shorter than would be the case if there was more of a balance between investment and contributions at this stage in a scheme’s life. 

While the new Code permits flexibility, Trustees will need to take ‘informed risk’ decisions based on a proper understanding of the covenant strength they have, the level of investment risk it can support, and the level of contributions that appropriately balances covenant, funding, and investment risks.  Otherwise, we may find that schemes and sponsors take risks which stop them ever reaching the summit.