Defined benefit pension schemes generally undergo a formal actuarial valuation once every three years. They have up to 15 months from the valuation date to submit a “recovery plan” to the Pensions Regulator, setting out how any deficit will be repaired and over what period. The most common valuation dates are in late March and early April. The way pension liabilities are calculated for these purposes is not the same as the way they are measured in company accounts.
Towers Watson estimates that for a scheme whose assets were 90% of its liabilities on 31 March 2011, the funding level determined on the same assumptions may only be 80% today if two-thirds of its assets were in equities. If changes to equity prices and gilt yields since March are taken into account, this could double the contributions required to pay off the deficit within any particular period of time.
John Ball, head of UK Pensions at Towers Watson, said: “To repair a bigger deficit, trustees need increased contributions from the employer or higher investment returns from their assets. If they can’t expect either of those things, the deficit must be paid off over a longer period, with members’ benefits less secure in the meantime.”
The precise impact of recent market movements will vary considerably with the circumstances of each individual scheme. For example, while a scheme with two-thirds of its assets in equities and one-third in index-linked gilts may have seen funding levels fall from 90% to 80%, a scheme with two-thirds of its assets in index-linked gilts and one-third in equities may have seen a 90% funding level fall to 85%.
John Ball said: “Most schemes are relying on higher investment returns from equities to do some of the heavy lifting when it comes to getting back in the black, and have significant exposure to market volatility as a result. An important question for Trustees and companies is: do they view recent events just as an example of that volatility or do they believe that something fundamental has changed which means they must anticipate lower investment returns between the valuation date and the time when benefits are paid out? If the former, they need to hang on for the ride which is likely to continue to be bumpy; if the latter, they need to consider what action they should be taking.
“Scheme funding agreements based on March 2011 valuations do not have to be finalised until next June, so we expect that trustees and employers will watch how things evolve over the coming weeks and months before nailing down their plans. For now, market volatility has cast a cloud of uncertainty over the agreements that will be reached on scheme funding.”
Over recent years, the Pensions Regulator has reiterated to employers that deficits should be paid off as quickly as they can reasonably afford.
John Ball said: “A more worrying economic backdrop does nothing to improve affordability. If trustees do not expect recent investment losses to be reversed, and if they allow the recovery period to take all of the strain, this could lead to a deficit being paid off over 30 years instead of ten years. Under the current regime, there is scope for employers to be allowed to pay off bigger deficits over a longer period, but changes being discussed in Europe could see much shorter maximum timescales imposed in future.”