Background

Our client sponsors a defined benefit pension scheme. The scheme has a large allocation to growth assets with a smaller allocation to gilts and bonds.

The Pension Regulators feedback from the last valuation was that the scheme was carrying too much investment risk.  While TPR recognized the scheme was backed by a strong employer, TPR was concerned about the ability of the employer to support investment risk, particularly as the scheme was closed to accrual and maturing. TPR asked the trustees and employer to consider de-risking before the next triennial valuation.

Our client, however, has strong feelings about investments and does not believe a large allocation to low yielding gilts would be best for its business. We were asked to carry out a modelling exercise to investigate if the employer was, in fact, able to support the investment risks.

Stochastic Funding Projection

A DB pension scheme with a large allocation to growth is exposed to equity risk. A small allocation to gilts and bonds also means exposure to interest rate and inflation risks.

To demonstrate the impact of these risks on funding, we carried out a stochastic projection of the scheme’s self-sufficiency funding level.

Our modelling shows that, because of investment risk, the scheme’s funding level is volatile. Deficit value-at-risk is large and, while the exposure to equities is expected to bring large surpluses, there is also a very real risk that funding falls to a dangerously low level. The probability that the scheme runs out of assets before all pensions are paid was calculated to be 19%.

Contingent Contributions

A key simplification in the modelling above is that it assumes no further employer contributions. That is, it assumes that the employer allows funding to fall dangerously low and pays no contributions even as the scheme begins to run out of assets.

That is unrealistic. As long as it remains solvent, the employer is legally obliged to pay whatever is needed to ensure pensions are paid in full. If necessary, all the profits of the business would need to be used to return funding to a safe level and ensure all pensions are paid in full.

A more realistic model should, therefore, allow for the contributions the employer would pay if investment risks crystallised and funding fell to an unsafe level.

A strong employer that can support investment risk will have no trouble paying whatever is needed to return funding back to a safe level. These contributions will only be a small proportion of the businesses profits, and a strong employer will be able to make sure pensions are paid in full even if interest rates fall or if equities underperform.

Revised Projections Allowing for Contingent Contributions

Our revised projections allow for employer contributions to commence as soon as funding falls to an unsafe level, with these contributions continuing for as long as funding remains weak.  As we are investigating if the employer is strong enough to cover investment risks, we only model affordable contributions that are not more than the businesses profits.

Our modelling showed that employer contributions of 10% of the businesses profits, payable while funding is at an unsafe level, may not be enough cover all investment risks. There remain scenarios where funding continues to deteriorate and there is a 7% probability that the scheme runs out of assets before all pensions are paid.

However contributions of 25% or more of profit, payable for as long as funding remains at an unsafe level, would be enough to cover all investment risks. Contributions at this level would ensure the scheme always has sufficient assets, and the probability of running out of assets before all pensions are paid is 0%.

We assumed, for modelling purposes, that employer rescue contributions (of 10%, 25% and 50% EBITDA respectively) would start if the self-sufficiency funding level falls below 50% (the 'unsafe' level) and would continue for as long as funding remained below this level. Adopting a higher 'unsafe' funding level, for example 60%, would mean that investment under-performance is 'caught' earlier while risk increases if we assume that action will only be taken when funding falls below 40%.

Conclusion

By allowing for corporate profitability, our modelling takes account of the relative size of the pension scheme and its sponsor. As we project the development of the scheme's finances over its lifetime, we also allow for the additional risks that arise as the scheme matures.

As well as allowing for increased employer contributions, our modelling can be extended to allow for other actions that the trustees and employer may take after a deterioration in funding. For example, closure to future benefit accrual, reduced transfer values and commutation factors and investment de-risking or re-risking

In this instance, we were able to show that the employer was able to support a higher risk investment strategy, and our modelling provides the evidence the trustees and employer need to demonstrate this.

Please contact us if you would like to discuss this.

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