What to consider, and the practice so far.
At a glance
- The impact of Brexit on pension plans is very much uncertain, adding to the risk that there are material changes from the valuation date to the date when the valuation is finalised.
- Trustees and sponsors need to weigh up the pros and cons of allowing for post-valuation experience.
- The flexibility in the funding regime to allow for post-valuation events has been used in around 1-in-5 recovery plans so far, most commonly where conditions have improved after the valuation date.
“When completing a funding valuation, legislation gives trustees and sponsors flexibility in whether to allow for developments since the valuation date, but is it the right thing to do? This conundrum is not a new one for trustees, but given the unknown impact of Brexit it is likely to be a topic that many trustee and sponsors might need to consider for valuations in progress during 2019”. Gareth Connolly, Senior Director, Willis Towers Watson
In this article, Gareth Connolly highlights some of the factors to consider when making a decision and also looks at how often trustees have made allowance for post-valuation events in the past.
What sort of events might you consider allowing for?
An actuarial valuation represents a snapshot of a scheme’s funding position at a point in time, the valuation date. Funding positions can change significantly between the valuation date and the date at which the valuation is signed off, which can be up to 15 months later.
In recent years, the main cause of volatility in scheme funding positions has been from movements in the financial markets. The chart in Figure 01, taken from Towers Watson’s Asset Liability Suite tool, shows the daily movement in funding position for a sample scheme.
“The main cause of volatility in scheme funding positions has been from movements in the financial markets.”
Figure 01. Movements in Technical Provisions deficit for a sample scheme since 1 April 2016
Figure 01 illustrates the deficit in the sample scheme. This deficit has gradually widened in the second half of 2016 following the Brexit vote, which is a result of falling bond yields but with some good news for pension fund investors in overseas assets where these were not fully currency hedged. The position has generally improved during 2017 and 2018 due to more stable bond yields and strong returns on growth assets, but with some recent setbacks due to worsening equity returns.
Other post-valuation events that trustees and sponsors would typically consider taking into account are member option exercises (such as pension increase exchanges or retirement transfer exercises), relevant benefit changes (such as scheme closures) or changes to the scheme’s investment strategy.
What does the law and the pensions regulator say about this?
The funding legislation simply states that a recovery plan must be ‘appropriate’ – which is very broad. It is silent on whether an allowance should be made for post-valuation events. Actuarial standards require a scheme actuary to make the trustees aware of any ‘material changes or events’ that occur after the valuation date, so that they can consider whether to make an allowance for them in the recovery plan.
“The funding legislation simply states that a recovery plan must be ‘appropriate’ – which is very broad.”
The Regulator has commented less on post-valuation date events in its more recent annual funding statements than previously. Instead it has focused more on integrated risk management and contingency planning in the event of a future downturn – the implication being that any future changes should be managed within the trustees’ risk appetite.
The 2018 annual funding statement does, unsurprisingly, contain references to Brexit uncertainty and the need for ‘open and collaborative’ conversations between trustees and sponsors.
One of the themes of the Regulator’s 2014 update to the funding Code of Practice was making use of the legislative flexibilities: “trustees can use the flexibilities available in recovery plans to ensure that they are appropriately tailored to both scheme and employer circumstances”, although the Regulator didn’t refer specifically to allowance for post-valuation events. A consultation on a new Code of Practice is expected to take place this year so it will be interesting to see in due course whether the Regulator’s stance will change to be more in line with the messages in their December 2015 publication on Integrated Risk Management.
Taking all of the above into account, it is therefore left to the trustees and sponsors to consider whether or not to make any allowance for post valuation events.
In some cases, trustees have taken the view that deficit volatility is inevitable and that there has to be a ‘cut-off date’ for funding level information when determining the recovery plan; using the valuation date is the most straightforward way to do this. Trustees may have felt that developments since the valuation date are temporary short-term fluctuations and have made no allowance for them; any post-valuation date experience, if it persists, will naturally be allowed for at the next valuation.
On the other hand, some trustees have preferred to use the latest available data when setting a recovery plan and to allow for post-valuation events, especially if changes in the economic environment are thought likely to persist. Use of an out-of-date snapshot position at the valuation date may be considered somewhat arbitrary if the trustees and sponsor are aware of subsequent developments, especially if they have easy access to up-to-date information.
Some trustees and sponsors may have developed a principle for whether to allow for post-valuation experience at each valuation; others may decide whether to make an allowance separately at each valuation based on the circumstances.
What has been done in practice?
Figure 02 looks at Willis Towers Watson data for nearly 1,000 recovery plans spanning the whole of the scheme-specific funding regime and shows the proportion of recovery plans that have made allowance for post-valuation experience .
Figure 02. What proportion of recovery plans make allowance for post-valuation experience?
The yellow tranches show where there was typically a material improvement in scheme funding levels as a result of financial market changes after the valuation date. For simplicity we have looked at changes from 31 March to the following 31 March, as many valuations take place around the end of the first quarter and are typically finalised a year later.
This analysis shows that:
- Overall, around 1-in-5 recovery plans incorporate allowance for post-valuation experience.
- The ‘tranche’ of valuations with the highest proportion of recovery plans allowing for post-valuation experience is ‘tranche 4’, with around one-third of schemes making an allowance. These valuation dates were typically around spring 2009, when the FTSE 100 fell below 4,000, but investment markets bounced back significantly over the following year.
- In years where a valuation date was followed by favourable financial conditions and a material improvement in funding levels (yellow bars), there is a greater tendency to make allowance for post-valuation experience in the recovery plan. For example, the ‘tranche 7’ valuations were broadly same set of schemes as for ‘tranche 4’ but as post-valuation experience was not favourable, only 13% of cases made any allowance for post-valuation events.
- The tranche most affected by the Brexit vote in 2016 was tranche 11, where nearly 1-in-4 schemes made allowance for post valuation events.
To the extent that Brexit causes a material change in funding positions during 2019 then we would expect the trustees and sponsors of the schemes affected (mostly ‘tranche 14’ schemes with valuation dates around the start of 2019 or spring that year) to consider these flexibilities. Having the ability to do this cost effectively will a major benefit to all parties.
“To the extent that Brexit causes a material change in funding positions during 2019 then we would expect the trustees and sponsors of the schemes affected (mostly ‘tranche 14’ schemes with valuation dates around the start of 2019 or spring that year) to consider these flexibilities.”
- Trustees and sponsors have flexibility in deciding whether to allow for post-valuation events when finalising a recovery plan.
- There is no ‘right answer’ as to whether to make such an allowance, and the approach for each valuation should be considered based on the circumstances and risk appetite at that time.
- The unknown impact of Brexit may well result in more schemes considering these flexibilities than has been the case in the past.