Weaker pension schemes set to lose out from the Pension Regulator’s funding guidelines - PwC analysis

Published at 11:31 AM on 29 April 2014

New PwC analysis reveals that if schemes with the weakest covenants follow the Pension Regulator’s draft consultation guidelines on integrated risk management and investment strategy they could risk increasing their collective deficits by £20bn.

The Regulator’s consultation on funding of defined benefit pension schemes, released in December and expected to be finalised later this year, sets out how it will monitor schemes by segmenting them based on the strength of their sponsoring employer – known as the employer covenant. According to the Regulator’s analysis, investment risk should be limited for approximately 1,100 schemes with liabilities of around £140bn that fall into the weakest covenant category, containing those companies where there are material concerns over the ability of the employer to support the scheme. Moving to a less risky investment strategy provides greater protection against a large decrease in scheme asset values and therefore provides greater certainty that members will receive a certain level of benefits.  The Regulator argues it is important for schemes with weak covenants to limit the amount of investment risk they run, however, the Regulator’s own analysis suggests that these schemes with weaker covenants currently have very similar levels of investment risk to schemes with much stronger employers.

While the precise levels of investment risk the Regulator would like to see for these schemes is not yet known, PwC’s analysis suggests that if these schemes take less investment risk this could increase their deficits by £20bn. This would translate to cash contributions doubling for those employers or an extension to the length of time employers take to pay deficits (known as the Recovery Plan) of over 20 years.  In some cases, the increase in contributions or recovery plan length will be too great for the employer, forcing difficult decisions.  The Regulator acknowledges this in the draft guidance saying pension schemes with weak covenants should be considering whether it is appropriate for trustees to consider their powers to wind up a pension scheme or to take other steps to avoid any potential worsening of the position.

Paul Kitson, partner in PwC’s pensions team, said: 

“Deficits can only be made good by cash contributions, other forms of non-cash assets or investment returns. Given the options available to schemes in deficit it is inevitable that those with weak covenants have often adopted riskier investment strategies in the hope that excess investment returns will help fill the funding gap where the employer potentially can’t afford to pay more. Schemes in these situations will need to work closely with their employer to understand the key risks in the business and the scheme to ensure they are not exposed to risks that could reduce the funding and sponsor strength at the same time. 

"Recovery plans might be much longer and some schemes will find that the deficit can never be repaid without taking significant investment risk – in these cases it might be necessary to consider alternative compromise options involving the Pension Protection Fund.”

Karina Brookes, director in PwC’s pensions credit advisory team, said:

“There is a need to understand how investment risk translates into reduced certainty in relation to members’ benefits being paid in full and whether the trustees, the corporate sponsor and ultimately the members are comfortable with the current level of risk in the scheme and therefore the likelihood that benefits will be paid in full.

“However, for those schemes at the weakest end of the spectrum, a move to a less risky investment strategy which causes a further increase in the deficit, may prompt the sponsor and the trustees into considering different pensions restructuring options in order to properly address the pensions issue.”

PwC’s analysis shows that while defined benefit schemes with the weakest covenants could be worse off based on the approach set out by the Regulator, those with the strongest covenants could emerge in a better position.

Analysis reveals that if the schemes with the strongest covenant grade, where the employer has strong trading, asset and cash generation relative to the scheme size and deficit, take more investment risk this could reduce deficits by around £50bn. For these schemes, which cover around £700bn of liabilities, this would translate to a £10bn a year reduction in contributions or a four year reduction in recovery plan lengths.

Paul Kitson, partner in PwC’s pensions team, said:

“Our analysis shows that schemes with strong covenants could afford to take more risk and potentially lower their contributions. Such an approach would be consistent with the Regulator’s new objective that pension funding doesn’t adversely affect corporate sustainable growth. However, there may be little appetite from some employers and trustees to take more risk and accept the inevitable balance sheet and funding volatility that goes with this even if the Pensions Regulator allows them the flexibility to do so.”


Notes to Editors:

  1. For further commentary on market issues, visit our pensions blog: pwc.blogs.com/pensions
  2. Skyval is a web-based pensions platform which sponsors, trustees and their advisers can use as a single tool to analyse the impact of changing pensions regulations and market developments. It is now being deployed by over £80bn worth of pension schemes. For more information please visit www.skyval.com


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