Members of defined benefit schemes may wish to transfer out to take advantage of the new pensions freedoms, but what impact will that have on scheme funding levels?

Lesley-Titcomb

What happened?

The Pensions Regulator has warned trustees to prepare for an increase in defined benefit to defined contribution transfers as a result of the pension flexibilities announced in the April 2014 Budget.

The Regulator points out that a large volume of transfers out of a DB scheme would have a significant impact on its funding levels, so trustees need to be aware and ready to respond.

The warning was included in the Regulator’s annual defined benefit funding statement, which was published in late May. This document sets out its stance on the funding of defined benefit schemes, particularly for those with valuations on the horizon.

The Regulator has taken a relatively lenient approach in this year’s statement as it acknowledges that market conditions have been difficult for defined benefit schemes and accepts that deficits may well have grown since the schemes’ last valuation three years ago.

The significant drop in interest rates and consumer price inflation was a particular concern. The statement points out that “long-term real gilt yields are now significantly negative and considerably lower than they were three years ago,” with the result that “many schemes with 2015 valuations will have larger funding deficits due to the impact of falling interest rates and schemes not being fully hedged against this risk”.

What does it mean for trustees?

Trustees will need to monitor member transfers out of their DB schemes closely and anticipate the impact that mass transfers could have on their funding levels. They should discuss what to do to mitigate the effect of transfers with their advisers. The Regulator also directed trustees to its guidance on DB to DC transfers, which can be found here.

Trustees are not expected to remove all risks from their schemes, but to manage and understand them. Specifically, the Regulator says they ought to be contingency planning and modelling what impact a range of scenarios would have on their deficits so they can take quick action and change their investment strategies should those situations arise.

The Regulator is keen to point out that schemes’ funding strategies must be specific to their own circumstances, taking into account their existing investment strategies and funding levels, employer covenant, and sponsor growth prospects.

What next?

The statement acknowledges that schemes which have acted prudently may still be able to take some additional risk, provided this does not mean they will have to change their recovery plans.

However, trustees who expected gilt yields to rise after their last valuation should consider the impact this calculation has had on their funding levels, and take action to address any shortfalls, either by asking the employer for higher contributions or an asset backed security, for example one of the employer’s properties. The aim should be to stick to the plan and keep the same recovery plan end date.

Where the employer’s situation has changed and they are no longer able to make contributions at the same rate, it falls to the trustee to carry out a higher level of due diligence and make sure they understand why the employer cannot commit to the same contribution regime. The trustees should then find out whether they can get contributions from elsewhere or set up an asset-backed contribution structure.