13 February 2018
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The Pensions Regulator’s 2017 annual funding statement sets out a new tougher stance for sponsors of defined benefit (DB) pension schemes. In particular, it is clear from the statement that the Regulator will be less tolerant in future of employers with underfunded pension schemes who prioritise payments to shareholders over payments to the pension scheme. Companies with annual dividend payments that are significantly greater than their DB deficit contributions are particularly at risk.
Understanding the risks
Businesses are under pressure to maintain high and stable dividends so the risk of regulatory intervention on dividend policy is unwelcome and something to avoid. In practice, normal fluctuations in the deficit in the pension fund can be absorbed by relatively modest changes to the funding plan and / or investment strategy. Sponsors often have enough margin in their business plan to accommodate these. The fund and sponsor are still in the world of business as usual.
However, growing increases in the pension fund deficit will drive the trustees to push for higher contributions from the sponsor. This may push cash requirements beyond business as usual with sponsors needing to re allocate resources to the pension fund and cut back on investment in the business and dividends to shareholders.
What can companies do?
For most pension funds, a large increase in deficit will be driven by some combination of falls in equity markets and falls in real / nominal interest rates. Therefore, reducing the exposure the pension fund has to these risks will reduce the chance of a painful increase in deficit.
The good news is that there is a range of investment tools available to pension schemes to insure against these risks. Be that, the risk of falling equity markets or falling interest rates. The insurance can be structured in many different ways to optimise the sponsor’s risk exposure and costs.
An action plan to manage the threat
Scheme sponsors should ask how exposed they are to pension fund risks and what scenarios might push them away from business as usual eg what events might disrupt the dividend policy or investment in the business? My key actions for sponsors to address this are:
- Assess what level of pension contributions are likely to be affordable
- Translate this into the maximum tolerable pension fund deficit
- Analyse investment offerings to insure against the deficit growing larger over the period to the next valuation and beyond, as needed
- Engage with pension scheme’s trustees to implement this insurance
This approach to risk management is likely to be exactly the sort of behaviour that the Pensions Regulator would encourage. Stability in funding and cash requirements are a benefit for both the pension funds and their sponsors.
You can find out more on how these investment tools work in practice in our latest video – watch it now.