Occupational Pensioners’ Alliance

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Occupational Pensioners’ Alliance

Scheme Specific Funding

Huw Evans Adrian Bourne23 October 2008

Copyright © Watson Wyatt Worldwide. All rights reserved

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Pension Scheme Funding

Stage 1 – Foundations

Stage 2 – Analysis and Decisions

Stage 3 – Putting it all together

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Stage 1 - Foundations Legislation

Code of Practice

Statement of Funding Principles

Balance of Powers

Potential Trustee / Employer conflicts

Funding process and Valuation Action Plan

Sponsor Covenant

Regulator Supervision


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EU Directive

sufficient and appropriate assets to cover the scheme’s technical provisions

Pensions Act 2004

• Statutory Funding Objective = sufficient and appropriate assets to cover the technical provisions

• Take account of specific characteristics of the scheme and sponsor

Technical provisions means the amount required, on an actuarial calculation, to make provision for the scheme’s liabilities

Stage 1

Legislation


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Objective assessment of employer’s covenant

Method and assumptions for technical provisions - trustees’ responsibility

Assumptions taken together should be prudent, but some risks are acceptable

Shortfall eliminated as quickly as the employer can reasonably afford

Stage 1

Code of practice


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• Explanation of the calculation of the Technical Provisions

• Details of Recovery Plan to meet the SFO

Employeragreement / consultation

Consideration of natureand circumstances of the scheme

SOC: Schedule of

Contributions

SFP: Statement of Funding Principles

RecoveryPlan

Actuarialadvice

Formal valuations can still be only

once every three years, but need

interim annual reports

Typically trustees and employers

must agree a Statement of Funding

Principles

Actuarial advice and guidance to the

trustees (and employers)

Stage 1

Statement of Funding Principles

Actuarial valuation


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Trustees Employer

Trustees’Actuary

Legislation /

Rules /Regulator

Legislation /

Rules /Regulator

Consult?

Agree?

Stage 1

Employer’s Actuary

Balance of Powers


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Trustees with senior management positions

Separate advisers?

Sharing of information and confidentiality

Need for constructive dialogue with Company

Stage 1

Code of Practice

• Any conflicts of duty or interest need to be recognised as soon as possible and dealt with appropriately

• Where appropriate, the Trustees should obtain legal advice as to how to manage these conflicts

Potential Trustee / Employer conflicts


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2. How should the fund be invested?

Benefits paid

Assets

Funding target Investment returns

Contributions

Existing assets

+

+

= Benefits

3. How fast shouldwe turn on the tap?

Stage 1

1. How high to aim

for?

Stage 1

Funding process


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Recovery Period

Other forms of member security

Investment strategy

Funding target

Technical Provisions (and other subsidiary targets)

How fast do you want to get back on track when below target?

More return-seeking assets like equities would mean lower expected contributions but more risk that the actual contributions required will exceed the expected value

For example, escrow arrangements or other forms of

contingent funding

Stage 1

Funding considerations


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Stage 1

Responsibilities

Dialogue withCompany

Timescales

Meetings

Sub-committees

Action Plan

Practical process


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How and where does covenant fit in?

Actuarial

assumptions

Investment

Risks

Covenant

Investment returns/VaR: What are the financial consequences if assumptions prove incorrect?

Recovery plans: What is the range of contributions that the sponsor can afford to make?

Technical Provisions: How might covenant strength align to confidence levels?

The Regulator expects trustees to have a good

understanding of the position of the scheme as an

unsecured creditor of the company


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Revision : What to expect of TPR under SSF- the Code of Practice

Para 57 – It is essential for the Trustees to form an objective assessment of the employer’s financial position and prospects as well as its willingness to continue to fund the pension plan’s benefits (the employer’s covenant).

Para 59 – The employer is obliged … to provide the trustees with such information as they … reasonably require … This includes information reasonably required to assess the employer’s covenant.

Para 92 – … trustees should consider … the ability of the employer to cope with the financial consequences of assumptions not being borne out by experience.

Para 101 – Trustees should aim for any shortfall to be eliminated as quickly as the employer can reasonably afford. What is possible and reasonable, however, will depend on the trustees’ assessment of the employer’s covenant.

Focus on the employer covenant through out the valuation process


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Earnings and cashflow

Business risks

Balance sheet

How strong is the balance sheet?

What is the nature of the assets therein?

Insolvency outcome: What are the prospects of

insolvency and an indicative outcome for the scheme?

How profitable/cash generative is the

business? And how is cash utilised?

Are the trends positive?

Relationship covenant

What is relationship between the employer

and wider group?

Is there any structural subordination?What are the future

prospects for the company?

How predictable are the earnings and cashflow?

What is the default probability?

….and willingness

Ability to pay

How do we assess covenant? Backward and forward looking….art not a science!


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Particular focus on irrecoverable zone….

Self-sufficiency

0%

20%

40%

60%

80%

100%

120%

1 2 3 4 5 6 7 8 9 10Year

Upper quartile

Median

Lower quartile

95th percentile

What if the investments under perform?

At what point does the strain become to much on the covenant?

Assessment will aim to identify critical issues and when risk becomes too great


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Monitoring the covenant!

CommentaryAll indicators remain positive. In particular: Gross profit has improved slightly year on year

(“yoy”). Cashflow remains strong albeit net cash levels

have decreased yoy due to acquisition spending and pensions contributions.

There is also strong net cash coverage. Similarly facilities headroom has also

decreased but remains at a level that is not covenant weakening.

The ratio of net cash as % of nwc remains strong and is explained in more detail on page X.

Revenue growth is buoyed by acquisitions but importantly the gross profit margin and PBT as a % of revenue ratios have both been maintained.

Headline PBT has also improved. Source data and explanations are set out on

page [ ].

Risk weighting Weak Negative Moderate Positive StrongFinancial statement indicators

BalanceSheet

Income Statement

Cash Flow Statement

Gross profit margin: 6.2%

(6.2%)

PBT : £77m (£76m)

Facilities headroom:

£641m (£785m)

Net cash: £246m

(£391m)

Annual BBPF deficit contrib

cover by h’room: 40.1x

Net cash as % of nwc:

27.6%

Revenue growth: 25%

PBT as a % Rev : 1.3%

(1.2%)

Figures in brackets represent six months to June 2007 results

Net assets: £550m (£513m)

Net cash coverage of

deficit contrib: 2.3x


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Buy-out cost

PPF FRS17

Liabilities

Technical provisions

Unlikely to investigate further

Very likely to investigate further

May investigate - maturity?

Stage 1

Pensions Regulator’s “targets and triggers”


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Pensions Regulator’s approach

Hands-off so long as they think things are moving to a conclusion

Work to bring parties together

They appears very keen to stay as a referee rather than a player

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Stage 2 – Analysis and Decisions

Establishing the funding plan

Integrated funding and investment

Assumptions

Recovery Plan

Contingent assets

Buy-out


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Funding level

Time

Buy-out

Gilts

Corporate bonds

Mixed portfolio

1. How much?

2. By when?

{4. Risk tolerance

A B C

3. Journey plan(balance of contributions + investment returns + risk tolerance)

?

?

Stage 2

Establishing the funding strategy


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Stage 2

Initial fundamentaldiscussions

Trial high-level investment strategy and technical

provisions

Refine investmentstrategy

Finalisevaluation

New trial

Resulting level of contributions, funding levels over time and

risk

Model the future-scenario orstochastic

Results acceptable

Results unacceptable

Integrated Funding and Investment


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Financial assumptions

Pre retirement discount rate Post retirement discount rate Inflation Salary increases Pension increases

Stage 2

Demographic assumptions

Mortality after retirement Mortality in service Rates of leaving service Rates of early retirement Rates of ill health Promotional salary scale Marital statistics

Assumptions


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Fundamental questions

What is the appropriate approach to setting discount rate for the Scheme?

1. to assume current investment strategy maintained?

2. to anticipate gradual switch from equities to bonds?

3. to ‘match’ assets to liabilities assuming lower discount rate after retirement (bond-based) and higher discount rate before retirement (equity-based)?

What is meant by prudence?

– Acknowledging that real life is variable

Stage 2


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Stage 2

Mortality assumptions

Need– “base table”: a snapshot of the mortality rates

expected over the year following the valuation

– “improvement factors”: i.e. how mortality rates will change in future

Never enough data to be confident of either No single “right” answer “cohort projections” are pretty arbitrary and rather

old by now tPR guidance reflects pushback on consultation doc


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Stage 2

Mortality beliefs

Total pace of improvement slows as deaths from heart disease and stroke become less common and other causes of death prove more difficult to eliminate.

Generations born in the post-war years continue to experience less rapid improvements as lifestyle-related illness take their toll.

As per “trend reversal”, but the pace of change in circulatory disease mortality also reduces sharply.

Typical justifications tend to focus on trends in cigarette smoking and/or rising obesity levels.

Who can tell what’s going to happen in the future… obesity, bird flu, climate change

…this whole mortality improvement thing is over-hyped

Medical advances continue to accelerate.

As each major cause of death is reduced, resources are re-deployed to tackle the remaining causes that have become more significant as a result.

Trend Reversal

Continued Acceleration

No Future Improvements

Extreme Trend Reversal


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Factors to consider: Strength of employer Balance of powers Trustees’ and Employer attitudes to risk Financial strength of scheme Maturity of scheme Investment strategy Consider buyout position Less prudent assumptions in recovery plan? Contingent security

“Agreed process to get back to full funding on the agreed assumptions”

Stage 2

Recovery Plans


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Trustees may consider less stringent funding objectives and/or longer recovery periods if the Employer were to provide contingent security

Contingent security could also influence the Trustees’ thinking on investment strategy (for example may be acceptable to retain a higher proportion of equities)

Could reduce PPF levy in future (but no effect in current funding position)

Stage 2

Contingent Assets


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Who cares about the buy out funding level?– Members and Trustees – level of benefits that would be provided if

Company were to become insolvent– Actuary required to assess buy out level both now and over the next 3

years– The Pensions Regulator – likelihood of having to call on the PPF in the

future– Shareholders / potential buyers – cost of extinguishing DB liabilities

Therefore you can’t ignore the buy out funding level

However…an alternative funding measure would be to concentrate on a closed fund positionclosed fund position or or self-sufficiency positionself-sufficiency position based on based on matching investments such as bonds

Stage 2

How important is buy out?


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Valuations go badly when…

Employer engages late in the process

Employer goes AWOL during process

Employer disagrees with covenant assessment


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Trustees fail to position themselves for a negotiation

Trustees start with an unrealistic negotiating position


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Agreements in principle are unpicked while drafting of the Statement of Funding Principles

Technical Provisions are set too high: consider other funding objectives

Conflicts are not managed properly

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Stage 3 – Putting it all together

Documentation

Beyond the valuation


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Valuation report

Contingent funding detail(if needed)

Schedule ofcontributions

Recovery plan(if needed)

Documentation

Stage 3


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Communication to members

Finalise investment position eg diversification of return-seeking assets

Review scheme options – commutation / early retirement / transfer values

Project review and lessons learnt for next time

Monitor progress against funding plan

Stage 3Stage 3

Beyond the valuation

Documents

Occupational Pensioners’ Alliance