1. Regulatory update on funding issues Fiona Frobisher October 2009

2. Agenda Scheme Funding Framework Robust Technical Provisions
Flexible Recovery Plans
Risk Transfers
TPR’s approach to cases
What you can do

3. Scheme Funding Framework

4. All schemes must perform a triennial valuation The process for trustees takes up to 15 months
…ROUND 1… ROUND 2…
Tranche 1
schemes
22/9/05 – 21/9/06
Recovery
Plans
Dec 06 – Dec 07
Tranche 1
schemes
22/9/08 – 21/9/09
Recovery
Plans
Dec 09 – Dec 10
Tranche 2
schemes
22/9/06 – 21/9/07
Recovery
Plans
Dec 07 – Dec 08
Tranche 2
schemes
22/9/08 – 21/9/09
Tranche 3
schemes
22/9/07 – 21/9/08
Recovery
Plans
Dec 08 – Dec 09
The scheme specific funding regime has now been in place for three years now.
We view scheme valuations falling into 3 tranches. The cycle starting back in 2005 with the introduction of the regime.
The valuations have associated recovery plans following in a period of 15 months after the valuation date.
The dashed line shows the position we are currently in.
As you can see most schemes have been through the valuation process now with a few recovery plans still to be submitted, and some schemes are in the throws of their next valuation.
You all may recognise where you are with respect to your scheme on this chart
The tranche 3 [Orange] recovery plans have valuation dates before the most recent falls in asset values – although any affordability issues employers are having because of the economic uncertainty are probably factored into the recovery plan submission.
Tranche 1 schemes [Blue] now have the added pressure of an economic downturn to factor into their second valuations, And we are beginning to see how employers and trustees are using their experience from the first round of funding discussions to inform this second valuation.
Although trustees have up to 15 months to agree a recovery plan they do not have to take all this time and a few schemes are already beginning to agree round 2 valuations.
…DEALT WITH… CURRENT… …FUTURE…
Sept Sept Sept Sept Sept Sept 10

5. Funding has weakened

6. And many employer covenants have weakened:
Real GDP quarterly growth: Source ONS

7. Robustness versus flexibility
Technical provisions:
must be robust;
need to reflect the situation as it really is, not as we may like it to be.
However:
Recovery plans can be flexible if needed.
Technical provisions must be Robust – it is within the interests of all to base them in reality
LOW TPs: Setting technical provisions at low margins of prudence means that parties are comfortable that the employer has the resources and the desire to underwrite the risk that your assumptions do not turn out as planned.
HIGH TPs: Setting a high target for TPs may be a reflection of a rational doubt about the employer’s ability to stand behind significant adverse volatility.
However, it is in everyone’s interest that the employer remains viable and healthy.
RPs: So, the cash demands on an employer should be reasonably affordable. The deficit should be filled as quickly as possible without endangering the health of the employer.
We believe that for many companies it is still possible to deal with deficits in a relatively short period with fixed contributions, and that is precisely what should happen.
But we recognise not everyone is in that position. Pushing a recovery plan out to infinity is not the answer but there is flexibility if that is needed. Affordability needs to be an open, frank and constructive conversation between the scheme and its sponsor.
We will now look at the employer covenant in a bit more detail … (next slide)

8. Robust Technical Provisions

9. Assumptions and employer covenant
Strong
Some
High
Covenant
Risk level of
assumptions
This slide is animated…
TPs are particularly sensitive to investment and other economic assumptions – actual experience in these areas is particularly hard to predict. De-risking can remove some volatility, but residual risks are underpinned by the employers covenant.
So, Prudence requires assumptions to take account of strength of employer covenant to stand behind any adverse experience.
Remember Covenant is:
Employers legal obligation, ability and willingness to support the scheme
The employer standing behind payments, not only the ongoing payments and expenses; but deficit repair and underperformance
And for ongoing funding, employer covenant provides security if actual experience is worse than assumed
Therefore, in practice what we would expect is:
that as covenant weakens [click]
the amount of risk that an employer can be expected to stand behind reduces [click]
and the overall level of prudence in the scheme valuation will need to rise [click]
Given the current economic circumstances, where employer’s covenant and cash flows are often constrained, and economic outcomes are hard to predict TPR is especially concerned about prudence.
Where we investigate schemes which have triggered we will have particular concerns where the level of prudence no longer appears consistent with the current covenant.
Another way of looking at technical provision levels can be by self-sufficiency …
Prudence
Little or none
Low
Weak

10. Employer covenant
Employers legal obligation, ability and willingness to support the scheme
Employer stands behind payments to cover:
ongoing payments;
appropriate scheme expenses
deficit repair;
underperformance
The first bullet should include ability as well as obligation and willingness.
The employer has several responsibilities to the scheme, including:
covering its ongoing needs,
payments to make good any deficits,
covering some expenses
as well as being able to stand behind under-performance
– this is the basis of the covenant.
This means that, in effect, the employer stands behind the full cost of meeting the liabilities of the scheme – Which could be seen as the cost to wind it up at any point in time.
However, with a supporting covenant, the pension scheme liabilities are on-going, and with an ongoing covenant the scheme should be funded to a technical provisions level to meet its liabilities as hey fall due.
Trustees must ensure that scheme funding targets – i.e. the technical provisions - are set at prudent levels, so that the scheme has sufficient resources to meet its on-going liabilities, and a margin to allow for unexpected outcomes.
This level of prudence needs to recognise the strength of covenant. The trustees must ensure that the level of any contingent liability on the employer to cover adverse experience is realistic, given the employer’s resources; and if not, the target funding for the scheme must be higher.
We don’t want to imply that there should be a direct inverse relationship between covenant and prudence - it is also acceptable for strong covenants to show strong levels of prudence in their assumptions, and this may reflect a general de-risking strategy they hold.
I have an animated slide that demonstrates the relationship between assumptions and employer covenant …

11. TPs + covenant = self-sufficiency
Technical provisions
Assets RP
Employer
Covenant
In a very simplistic manner the value of the employer covenant and the technical provisions should provide equivalent security to self-sufficient level of funding.
Self-sufficiency funding levels are an amount which can be expected to meet full accrued benefit liabilities and expenses in the future, after substantially de-risking and then allowing adequate reserves for any residual risks.
In other words, a position where members benefits can be delivered with a very high degree of confidence despite no future support being available from an employer.
The technical provisions are made up of assets and any recovery plan needed to reach the technical provision funding target.
The deference between TPs and self sufficiency is the covenant.
The recovery plan is an asset of the scheme; we treat it as an actual debt on the employer that must be paid as soon as reasonably affordable.
With a weaker employer covenant the amount of TP’s grows until it needs to replicate the self-sufficiency rate. This may mean the scheme funding deficit rises if current assets aren’t sufficient, and the debt on the employer is larger.
This can be a bitter pill to swallow for trustees and the sponsoring employer. However all need to be clear, realistic and in agreement about the comfort levels and the long term security provided by the covenant - This provides a robust starting position to fund the scheme.
For very weak employers…..
Self-sufficiency level of funding

12. TPs + covenant = self-sufficiency
Technical provisions
Assets RP
Employer
Covenant
…. or sponsors that are very small in the context of the scheme, the amount of TPs grows until it needs to replicate the self-sufficiency rate.
This does not mean the scheme needs to push an employer into bankruptcy – And hopefully steps have been taken before any such point to limited the liabilities of the scheme facing the employer - we have been clear about the flexible nature of recovery plans, where employers are in difficulty.
I will talk about flexibility in a moment, but notwithstanding the flexible nature, trustees cannot ignore the substantive position of the scheme in terms of member security.
Self-sufficiency level of funding

13. Flexible Recovery plans

14. Flexibility in recovery plans
Recovery plans should reflect what is possible and
reasonably affordable…..
but members should not be disadvantaged by terms of plan
Considerations for flexibility
Additional security to support longer plans
Contingent assets
Parental guarantees
Back-end loading
Step up payments once cash constraints cease
Agree profit share over and above flat rate payments
Additional security may be difficult to find in the current economic climate.
however banks are demanding more security to back their lending to employers.
Trustees need to ensure that the pension scheme is treated properly relative to other creditors and equity holders and recognise the schemes position in the capital structure both in an on-going situation and on insolvency.
A word on contingent assets – there is a need to take care to value them accurately. For instance in the case of a parental guarantee – you will need to know how enforceable that is and to think about the covenant of the company offering the guarantee- what happens if they become insolvent?
It is important to look at the widest set of options even though the sponsor may be cash constrained now – does the covenant assessment support agreement for increased payments 3 or 5 years ahead?
The next slide looks at an example of just such a recovery plan.

15. Example of a flexible recovery plan
Deficit = £14 million
Company cash-constrained;
reasonable expectations of recovery in year 4.
Payments £1 million yrs 1-4
Payments £1.5 million yrs 5-8
Payments £2 million yrs 9-10
In addition:
If company reaches certain triggers e.g. profit of over £1
million a year it will pay 25% profit a year to pension scheme.
There are many different ways of re-shaping recovery plans. We all want to be in a good position to take advantage of a recovery in the economic climate.
It is important to ensure that when you write flexibility or contingent arrangements into a plan everything is properly written into contract and enforceable.
In this case – trustees accept that employer is particularly cash constrained for next few years and accordingly agrees to a back-end loaded recovery plan.
For sake of simplicity we have ignored interest and other detail issues.
Even with back-end loading the recovery plan is longer than trustees would like therefore they agree a profit sharing provision with employers whereby if the employer performs more strongly than predicted, extra payments will be made to the scheme, thereby reducing the length of the recovery plan as target will be reached earlier.

16. Risk Transfers

17. The regulator’s role in management of pension risk transfer
We welcome innovation in the market but our focus remains on protecting member benefits and reducing calls to PPF
Such transitions can introduce new risks
Where risk is transferred to another entity need to ensure no reduction in member security
Where risk is transferred to individual member need to be properly informed of risks and costs
Rather than a risk transfer being a one-off, often part of a phased/ blended solution

18. Our approach; your approach

19. TPR approach to funding cases
Work with employers, trustees who need to revise recovery plans
Where recovery plans trigger we will be particularly concerned by those that show a drop in prudence
Welcome recovery plans with additional security
We are happy to discuss issues around corporate transactions, the earlier we are involved in the process the more we can help
We have powers – but most cases are settled before they are used

20. What you can do: Work with the trustees: Understand your position
Communicate openly
Start early
Ask the right questions

21. Thank you