TPR's Annual Funding Statement 2023

The Pensions Regulator (TPR) issued its 2023 Annual Funding Statement on 27 April. TPR publishes funding statements each spring with important and relevant messages for trustees and sponsors of Defined Benefit (DB) pension schemes.

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Who is the statement intended for?

The statement is primarily aimed at trustees and sponsors of schemes undertaking funding valuations with an effective date between September 2022 and September 2023 (or 'Tranche 18' schemes).

The statement is also aimed at schemes “undergoing significant changes that require a review of their funding and risk strategies” as well as those schemes “that may be receiving requests for reduced contributions, amendments to contingent asset arrangements, and proposals for other uses of surplus”.

It is fair to say, therefore, that the statement will likely be relevant reading for most DB schemes.

The Regulator has also reiterated that the target effective date for its new Funding Code of Practice is now 1 April 2024.

What are the key messages from TPR?

Improved funding positions for most schemes

TPR acknowledges upfront that most schemes’ funding levels will have improved following the significant rise in gilt yields during 2022 and encourages schemes to review their long-term targets, as endgames will likely have become a much nearer prospect. TPR considers schemes in three different groups, and sets out the key actions for each:

Group 1: Funding level at or above buyout (TPR estimates around a quarter of all schemes are now in this position)

• Consider whether to ‘execute any previously agreed endgame plans’.  This will involve checking the scheme rules, taking advice and consulting with the sponsor.
• Consider surplus management strategies, for example using surplus to fund expenses or future accrual, or as an additional 'risk buffer'.
• TPR acknowledges that some trustees and sponsors may decide that running on the pension scheme might be a better option than buying out benefits (allowing, for example, members to benefit from surpluses in the form of benefit improvements).  However, it asks trustees and sponsors to consider the risks of doing so and how these can be mitigated.
• It is also notable that TPR makes no mention of its expectation for how such schemes should approach setting Technical Provisions, perhaps reflecting a view that Technical Provisions are not as strategically important for ‘Group 1’ schemes.

Group 2: Funding level below buyout but ahead of Technical Provisions (TPR estimates that most schemes will find themselves in this scenario) 

• Most schemes’ longer-term targets will generally be within closer reach than 12 months ago. Trustees and sponsors should review those targets along with any trigger frameworks and look to accelerate endgame plans if possible.
• Take the opportunity to align funding strategies with the draft DB Funding Code (see our interactive briefing note).  Formal ‘early adoption’ for such schemes might have been an encouraging target but for the delay to the finalisation of the code.

Group 3: Funding level below Technical Provisions

• Schemes should focus on 'bridging the gap' to Technical Provisions first.   
• As for Group 2, trustees should review their Long Term Funding Target as per the draft DB Funding Code, taking into account any scheme-specific impact from recent rises in gilt yields (and with specific reference to TPR’s Liability Driven Investments (LDI) guidance if relevant).

Call to ‘bank’ any gains through de-risking

For ‘Group 1’ schemes TPR flags the limited capacity within the buyout market and suggests that schemes should make preparations to make a prospective transaction as attractive as possible.

In the meantime, TPR impresses on schemes the amount of work involved in these preparatory stages (including investment strategy, transaction advice and data cleansing activities) which could take years to complete. Accordingly, TPR gives a clear steer towards de-risking schemes' funding and investment strategies to protect any favourable movements in funding positions while this work is undertaken.

TPR urges even those schemes for which endgame is not a near prospect to consider banking funding level improvements through de-risking activities.

Some schemes will not have fared so well

TPR noted that some schemes’ funding positions will have worsened because of the market turmoil following the 'mini budget' in September last year. These schemes are encouraged to reset their funding and investment strategies towards their long-term targets and to review their operational governance processes in relation to LDI. Trustees are directed to read TPR’s LDI guidance. 

Covenant remains key

TPR reminds trustees that risk should be supported by the sponsor covenant. Trustees should not become complacent with covenant monitoring activities and should ensure effective information sharing protocols are in place. Trustees should obtain independent specialist advice to help them where needed.

Trustees are warned about 'covenant complacency' as a key risk. Sponsor covenants may appear proportionately stronger now relative to improved scheme funding positions. However, sponsors will be bearing the brunt of historically high inflation rates, low economic growth, soaring energy costs and increased borrowing costs.

Trustees with sponsors experiencing distress are directed to TPR’s guidance on Protecting schemes from sponsoring employer distress. TPR also reaffirms its intent to release updated guidance on assessing sponsor in conjunction with its updated DB Funding Code.

Regulatory regime

Finally, TPR confirms that the existing DB Funding Code and legislation applies to all ‘Tranche 18’ schemes. TPR now expects the updated legislation and revised DB Funding Code will come into force from 1 April 2024.

What else does TPR’s statement say?

Open schemes

TPR notes that open schemes may be seeing reduced future service costs and relatively more material movements in funding level. Open schemes are more likely to be more focused on Technical Provisions than endgame targets and will have a wider choice of strategies available to them than comparable closed schemes, including retaining higher levels of risk for longer.

Revising recovery plans and contingent asset arrangements as part of a valuation 

Trustees may find sponsors request reductions in cash and non-cash security to schemes in light of improved funding positions. In response to such requests, TPR says it expects trustees to consider:

• The level of prudence in funding strategy and investment risk being carried before agreeing to any reduction in Deficit Reduction Contributions (DRCs). 
• If a deficit persists, trustees and sponsors should consider reducing the Recovery Plan length or removing any allowance for investment outperformance before reducing contribution payments (particularly if the remaining Recovery Plan period is more than six years, and not at all if covenant leakage is material).
• Where DRCs are reduced, TPR encourages trustees and sponsors to agree a mechanism for switching contributions back on if the funding position deteriorates. 
• Contingent assets may appear more favourable when assessed in 'nominal terms' against the reduced size of the scheme. Sponsors may seek to renegotiate terms and trustees should evaluate such proposals critically.

Investments

TPR acknowledges that for many schemes, macro-economic changes during 2022 will mean that current asset allocations may be significantly out of line with where they were expected to be. TPR suggests that schemes’ investment strategies will need to be reviewed in light of trustees’ and sponsors' reassessed long-term objectives, for example if lower investment returns are now required or if investment strategies are to be otherwise de-risked given generally improved funding levels.

TPR reiterates the operational risks associated with LDI that were highlighted in late 2022 and again directs sponsors and trustees towards its recently published LDI guidance.

TPR also draws attention to the fact that illiquid assets may now represent a larger proportion of schemes’ investment portfolio following the recent increases in gilt yields and encourages schemes to discuss the implications of this with their investment advisers.

Mortality and inflation assumptions

TPR has noted that “over the last year and a half, mortality has begun to stabilise at a rate higher than in 2019 (pre-pandemic)”. TPR says that a degree of caution will be needed in interpreting the recent data while new trends emerge, but acknowledges that the available data indicates shorter life expectancies. Notably, TPR has not commented on potential regulatory intervention where changes to schemes’ life expectancy assumptions significantly reduce liability values (as per its 2022 Annual Funding Statement).

TPR’s messaging around inflation remain unchanged from its 2022 Annual Funding Statement.

Assessing refinancing risks

TPR notes that the current economic conditions will likely impact on sponsor refinancing costs given material increases to interest rates. Trustees are encouraged to factor this into their covenant analyses. 

Indeed, TPR expresses its view that “where the refinancing is expected to be well progressed prior to the completion of the valuation, [trustees] should already be fully engaged in the process” and that “we do not expect [trustees] to finalise your covenant analysis until the terms of the refinancing become clear and they can be fully factored into your covenant conclusions”.

Scheme characteristics tables

Finally, TPR has provided updated tables of key risks similar to previous anual statements setting out the specific risks that trustees should be focussing on depending on the strength of the employer and maturity of scheme membership. This year's key risks tables are largely unchanged from previous editions of the Annual Funding Statement.

Summary and next steps for all schemes

The 2023 Annual Funding Statement is in line with TPR's recent messaging on scheme funding and investment, and through its LDI guidance following the market events of 2022.  TPR has suggested actions as follows:

• assess scheme funding positions;
• trustees to review funding targets in consultation with scheme sponsors;
• review funding and investment strategies with a view to de-risk and ‘bank gains’ where possible (and with regard to the draft DB Funding Code); and
• continue to monitor the sponsor covenant.