How did 2020 impact DB pension scheme stakeholders? Paul Brice looks at 10 themes for DB pensions in the coming year.
2020 was a year to forget for many, but for defined benefit (DB) pension scheme stakeholders, there are undoubtedly lessons to be learned from the turbulence that has shocked our economy. Let's look at 10 key themes that will be influential in the DB pensions world going into 2021:
1 The benefits of hedging unrewarded risk
When the impact of COVID-19 first took hold, DB pension schemes with a well-hedged investment strategy were most resilient. Schemes with high levels of hedging saw lower initial falls in assets, whereas those not well protected typically experienced more volatile funding positions.
With long-term funding targets and a move to ‘self-sufficiency’ being emphasised by The Pensions Regulator (TPR), there is likely to be further focus on considering the hedging of unrewarded risks for many DB pension schemes.
2 Goodbye RPI
However, despite this resilience, confirmation in November that Retail Price Index (RPI) will be aligned with the Consumer Prices Index including owner occupiers' housing costs (CPIH) with effect from 2030 has resulted in some well-hedged DB pension schemes being disadvantaged.
DB pension schemes with mostly CPI-linked liabilities that have hedged inflation risk have lost some ground as the value of their hedging assets falls with no equivalent offset in the value of their CPI-linked liabilities.
The impact this will have on liability valuations over the interim period to 2030 is unclear as various approaches of incorporating the change into assumptions are still being considered, putting this firmly on the agenda for 2021.
3 Cash may need to be tomorrow’s king
Cash contributions are a central component of DB pension scheme funding, with contribution negotiations often pushing for more of it and as quickly as possible.
In 2020 many DB pension sponsors saw sharply reduced free-cash availability. DB pension scheme contribution commitments have often needed to share a much smaller cash pie with other stakeholders. Contribution agreements that combine cash with some form of contingent support arrangement or asset, or that allow payments to be linked to employer performance, have needed to be considered in scheme funding discussions so as to preserve sponsor survival and longevity.
Faced with an exceptionally wide fan of doubt around future sponsor performance, recovery plan discussions will often have no choice but to consider alternative, more creative, solutions.
4 Where do I rank?
Whatever form of contribution plan is agreed, TPR expects trustees to ensure that it results in equitable treatment of the DB pension scheme relative to other stakeholders, and the affordability issues faced by many scheme sponsors during 2020 have highlighted the importance of this.
It's essential that trustees understand the sponsor's cash commitments and where the pension scheme ranks in priority relative to the competing obligations of the sponsor. Equitable treatment of the DB pension scheme is brought into sharp focus under abnormally stressed circumstances and there is likely to be continued scrutiny of this given continuation of tough times into 2021.
5 Scenario planning for changes in sponsor covenant
TPR has stressed the need for scenario planning in a covenant context for some years. 2020 has shown the value of planning potential responses to covenant volatility, and in seeking to be on the front foot in designing and implementing pre-agreed contingency plans.
I expect that trustees will be continuing scenario and contingency planning during 2021 so that they are well-equipped to respond to a broad range of sponsor changes.
6 Ongoing monitoring has never been more important
2020 has surely emphasised the crucial importance of covenant monitoring.
The shockwave of the coronavirus situation has shown that what might sometimes have been a relatively infrequent activity for some DB pension schemes – perhaps because their sponsor’s trading outlook seemed predictably robust – has needed much more focus.
Governments and lenders alike have been supportive of employers through 2020, but many employers have been left with reduced reserves, increased debt and lower earnings. As the impact of continued pressures feeds through to businesses, and working capital cycles unwind, many employers may continue to face intense liquidity pressures.
Unfortunately, 2021 could well be marked by acute employer distress in some sectors. This needs to be monitored and trustees need to have a plan to respond.
7 Regulatory tempo has been a helpful anchor
In recognition of the difficulty facing many DB pension schemes, throughout the year TPR have issued guidance making their expectations clear while signalling acceptance – in appropriate circumstances – of, for example, extended reporting timeframes and limited contribution deferrals.
In many sectors, this guidance has acted as a helpful anchor for trustees and sponsors seeking to determine appropriate responses to unprecedented trading conditions.
8 Superfunds are (almost) go!
Significant headway has been made during 2020 towards establishing the superfunds market. TPR has published guidance setting out expectations from providers in the interim period before legislation is finalised.
Will 2021 will be the year when ‘superfunds are go?’
9 Equalisation is still generating more challenges
Over 30 years after the Barber judgment was issued, equalisation rumbles on.
The Lloyds Bank pension schemes case sought clarification from the High Court around the process for equalising Guaranteed Minimum Pension (GMP) benefits, and the most-recent determination confirmed that transfer value payments also need to be considered: historic cash equivalent transfer value payments from a DB pension scheme must be revised and equalised.
This presents a further challenge for many DB pension schemes and administrators going into 2021.
10 Virtually all DB pension scheme governance can be virtual
Closing on a more-generic observation, after the initial scramble to ensure broadband signal was sufficient in our newly-created home offices, and forced on-the-job familiarisation with the array of communications software platforms now available, there has been an impressive transition to doing almost everything online.
With trustee meetings by video-conference from home, the transition has been rapid and effective. Will it reflect a 'new normal'?
To discuss any of the above themes, contact Paul Brice.