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Tranche warfare

The Pensions Regulator (TPR) is often to be heard talking about ‘tranches’. In their lexicon, a tranche is the cohort, group or section of each year’s schemes that go through the Part 3 valuation process.In this newsletter, I mainly want to focus on the triggers the regulator has covered in its December 2010 publication ‘Recovery Plans – Assumptions and Triggers’. The table below shows the 4 tranches reviewed by TPR up until 31 August 2010 – 4 is not complete, as the full tranche period runs up until December 2010.

Recovery Plans - Assumptions and Triggers 2010

Let’s look at the technical provisions (TP) trigger. We can see that 51% of those schemes who were the guinea pigs for the scheme funding regime, triggered on TPs. Understandable really. At that stage, nobody had any idea what technical provisions meant – indeed, there are still many differing views within industry on that very point.

We can see from tranche 2 though, that schemes and their advisers understood the game a little better the following year, hence the drop to a 35% trigger rate. This was roughly maintained the following year, with the impact of the economic climate clear to see in 60% of Tranche 4′s schemes triggering.

Naturally, this hike in schemes that don’t slip under the regulatory wire for TPs, is not down to a lack of understanding of the funding process. After all, these are the same schemes as Tranche 1, plus a few more that didn’t have deficits in 2005/2006, but now do. The following tables show the schemes that triggered on TPs, in tranche 1, tranche 4 or both.

Schemes that triggered on TPs, in tranche 1, tranche 4 or both

This high trigger rate was down to the financial pressures being brought to bear on sponsoring employers and, therefore, schemes. This is where the counter-intuitive point regarding TPs no doubt has a part to play. When in times of financial difficulty, covenant is likely to be impacted negatively, therefore TPs must rise. The tough part is understanding that, in the real world unless a scheme is close to being fully funded in, say, 3 to 5 years, technical provisions may not be the main consideration for schemes and employers, despite taking primacy for TPR. Covenant and what is reasonably affordable for the sponsor are, however, of vital importance.

Let me explain that further. The regulator insists on primacy of TPs, but schemes and employers may not see it that way. Whilst the calculation of technical provisions does retain huge importance (as I have said in a previous missive) TPs hang off of covenant and assumptions with reasonable affordability then providing the length of the recovery plan. For this very reason, it is natural for those involved in the scheme funding negotiations to look to covenant and reasonable affordability, before turning their attentions to the TP target.

So if we take the rather bold step of assuming TPs will fall into place and focus on the real issues for schemes and employers, we can look at the remaining 3 triggers, all of which have seen year on year increases after the initial drop from tranche 1 to tranche 2.

Despite the then Chairman, David Norgrove, stating in December 2008 that TPR would allow greater flexibility on back-end loading during the recession, figures have remained relatively steady. As deficits have increased, so have the numbers of schemes triggering on recovery plan length and investment returns. The latter increase is probably more down to schemes looking to appease employers by aiming for aggressive returns on investments, over-optimistic estimates of the length of the recession or a combination of the two. The following tables show the schemes that triggered on recovery plan length, in tranche 1, tranche 4 or both.

Schemes that triggered on recovery plan length, in tranche 1, tranche 4 or both

I have no doubt that the regulator will want to see a downward trend in these trigger rates. I understand that this very message was communicated to actuaries recently by TPR. I do not, however, predict a step-change reduction as there was between tranches 1 and 2. With the economy beginning to show signs of recovery (an increase in M and A activity being a good indicator of increased confidence), there might be a slight reduction in schemes triggering on TPs as covenants improve, which is likely to have a knock-on effect to recovery plan length. I see investment return continuing to trigger at significant levels as trustees look to make up time for scheme funding either treading water or moving backwards in recent years. I wouldn’t expect there to be much of a change in back-end loading either as employers look to the future for increased levels of profit.

For employers and trustees, I would send this message – if your scheme is not close to being fully funded, assess and understand the covenant of the sponsoring and participating employers, along with what is reasonably affordable for them to make available to the scheme, by way of deficit repair contributions and then turn your attentions to technical provisions.

The regulator’s full report ‘Recovery Plans – Assumptions and Triggers’ can be found here.

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