First Actuarial Client Conference – Thursday 6th October 2022

Session 1 | The Pensions Regulator’s new Defined Benefit funding code

Andrew Dodd and Mouna Turnbull provided an update on the Defined Benefit (DB) funding code.

Mouna set out the key objectives of the code, which are to make sure that trustees:

• Demonstrate compliance with legislation
• Think about their investment and funding strategies on a long-term basis
• Understand the risks they are taking and manage those risks
• Provide more transparency around risks.

TPR recognises that risk can be positive, but will ask schemes to gauge the optimal level of risk in a range of circumstances and consider the best way to manage that.

TPR is keen to avoid placing a heavy burden on smaller schemes, and will provide clear guidance on a proportionate approach.

Andrew Dodd took the conference audience through the twin-track route that schemes will be able to use to demonstrate compliance.

The ‘bespoke’ approach provides a flexible, scheme-specific approach to compliance. Trustees will produce a statement of strategy providing evidence that their risk is supportable. Schemes are likely to experience more regulatory involvement, but TPR will take a proportionate approach.

The ‘fast track’ approach is a simpler route that trustees can take to reduce regulatory involvement. It’s likely to be based on tolerated risk that TPR thinks a scheme can take in view of its covenant. Andrew warned that the fast track approach won’t be appropriate for all schemes.

TPR is planning to publish the code by the end of 2022. The full package of legislation and code will come into force at the end of 2023. At that point, schemes with an effective date that falls after the code and the legislation come into force will need to comply. Until then, the primary legislation and current code remain in force.

Session 2 | Current investment issues for trustees

Richard Lunt outlined the recent market turmoil around gilts and Liability Driven Investments (LDI) and its impact on pension schemes.

In the UK, inflation is currently 10%, despite a policy objective to keep inflation under 2%. The Bank of England had been trying to combat inflation by raising interest rates. Meanwhile, the Government announced tax cuts funded by additional borrowing – an inflationary policy. The market snapped.

The result was a run on the gilt market. At the start of the week, the 10 year gilt yield was 4%. And then it quickly rose to over 4.5%. As gilts fell in value, investors who couldn’t bring down their leverage using cash were forced to sell gilts. The problem was that nobody would buy gilts. So the Bank of England had to step in.

The impact of a significant fall in gilt prices following a long period of high prices will depend precisely on how much hedging an individual scheme has and how well it has worked.

How does LDI fit in? When schemes buy LDI funds, they’re effectively buying economic exposure to gilts funded partly by borrowing. Many schemes use LDI to hedge against market risks. This can be a valid approach as long as the risk is mitigated, notably by keeping leverage low and ensuring cash is easily available if needed. Where this fails, and leverage is too high, LDI fund managers can be forced to reduce borrowing by selling gilts to the market at low prices.

How did pension schemes fare? That very much depends on their investment portfolio.

Many found themselves in a better position than before. The significant majority of LDIs walked away unscathed from a colossal shock. However, a small minority had to sell gilt exposure at a low price and buy more gilt exposure at a higher price.

Is LDI still appropriate for schemes? Schemes should assess their portfolio in the round, taking into account other factors such as the impact of high interest rates on property funds. There’s no substitute for studying your individual scheme’s financial position and investment strategy.

Session 3 | High inflation – a legal perspective

Catherine McAllister discussed how inflation affects the calculation of member benefits and options.

Catherine takes a simple example of someone who left pensionable service in 2009 with a pension of £1,000 and decided to take early retirement in December 2022. They could potentially face a cliff edge in the pension benefit they receive. Retirement in December 2022 – using a common approach to early retirement – would give them a pension of £12,920. Whereas if they waited just a month, they would get a full inflationary uplift, equating to an extra £1,000 pa, if the appropriate inflation measure was 10%.

This cliff edge has always affected potentially members who retire in December, but high inflation now makes the difference stark. Trustees and advisers need to consider alternative approaches to early retirement to treat members fairly.

Catherine outlined a number of options. These range from doing nothing now and adjusting the calculation later, to a complete rework of the early retirement methodology and factors. The latter may not be an attractive option in volatile market conditions.

With increases to deferred pensions, Catherine explained that the cap on statutory increases to deferred pensions is applied cumulatively. As a result, following a long period of low inflation, many members will receive a full 10% increase on 1 January 2023 because headroom has built up.

With pensions in payment, the cap is usually applied annually and is not cumulative, so high inflation is less of an issue.

Due to inflationary pressures, more scheme members are complaining about issues like caps, the move to RPI and discretionary increases. Catherine encourages schemes to put in place a formal process to review the case for a discretionary increase. Trustees can then demonstrate that the review has taken place if, for example, a member takes the matter to the ombudsman.

Session 4 | The risk transfer market

First Actuarial’s Phil Kelly set the scene by outlining trends in the buy-out market. The market is busy, and will become more so, due to factors such as favourable market conditions and pent-up demand post Covid. Many schemes are already in the market, working with insurers.

Insurers are expecting demand to rocket into next year, and are already selective about the schemes they quote on. This is a particular concern for smaller schemes, with which it’s becoming more common for insurers to insist on exclusivity before agreeing to quote.

It’s still possible for smaller schemes to complete deals, but it’s important to stand out from the crowd. Phil advises schemes to prepare thoroughly and be flexible with timescales.

The session outlined a case study of a journey to buy-out, involving First Actuarial and Pension Insurance Corporation (PIC), a buy-out insurer. The scheme was sponsored by a UK-based manufacturer. The sponsor ran into difficulties and, due to the scheme’s large deficit, the parent company agreed to fully fund the scheme with the target of an eventual buy–out.

The additional funding from the parent company and good returns on investments meant that the scheme achieved full funding on buy-out within target timescales. First Actuarial carried out a series of member option exercises, which also helped reduce the buy-out costs. One of the most successful exercises was flexible retirement options – early retirement was especially popular.

Following a competitive tender exercise, PIC was chosen as the buy-out insurer. A strong point of reassurance was the focus of PIC on the member experience – payments on time, clear communications in plain English, and highly rated customer service.

Conference 2022 | Session 5 summary | James Woudhuysen

James Woudhuysen opened the session by urging pension schemes to ask a number of questions when considering green investments:

• What is the big picture? When considering renewable energy, trustees should bear in mind that energy is an interconnected system.
• Who is in charge of the innovation you’re considering? Their outlook is as important as the science when it comes to successful adoption.
• Will it incur reputational risk? For example, in the electronic vehicle battery market, the mining of raw materials involves child labour. Check out the ethics and the safety of what you’re investing in.
• Are we being realistic about fossil fuels? Renewables are still intermittent and require a constant back-up supply and a complex, intelligent grid to handle them.
• Will it create jobs in the UK? The reality of the solar park industry, for example, is that there will be no real job opportunities here for maybe the first 20–50 years.
• Which green technologies are worth investing in? James recommends that schemes look at geothermal technologies, small modular reactors and manufactured homes.

Above all, James asks people to shrug off the catastrophism and alarmism that permeates our culture. If there is a real crisis, we need to keep a cool head and take a balanced view when calibrating risk. When discussing investments, trustees should not only do the research, but also critique each other in an open-minded way.