As part of its new strategic guidelines, the Pensions Regulator has hinted that it will accept longer recovery plans from under-funded UK schemes. The Regulator’s new corporate plan notes: “We are operating in an economic climate far removed from the context in which we began in April 2005 and have reviewed our plans for 2009-2012 accordingly. Clearly, recent economic conditions will have an impact on schemes moving forward and we would expect to see this reflected in both funding and recovery plan lengths.”

The more flexible language takes into account the deterioration in the coverage ratio of UK schemes. The coverage ratio of 7,400 defined benefit schemes dropped from 97% in March 2008 to 76% in March 2009, according to the Pension Protection Fund (PPF). In its previous report, the Regulator suggested a recovery period of ten years for under-funded schemes. Recovery lengths will now have to be extended, though the Regulator has not endorsed a specific timeframe.

 “Many pension trustees have become entrenched on the Regulator’s trigger point of ten years,” says Simon Banks, principal at Punter Southall. “Previously only a small minority of companies found a ten year recovery plan as unachievable, but this is no longer the case.” Before the credit crisis took hold, an analysis of recovery plans submitted to the Regulator by defined benefit schemes showed recovery plan lengths had fallen, employer contributions had grown, and pension fund assets as a percentage of technical provisions had increased to 90% from 86%. This is no longer the case with consultants reporting that schemes with large deficits are moving to a 15-year recovery period with the tacit approval of the Regulator. “The market has helped set the tone. We believe a well-explained fifteen year recovery plan would be much less likely to result in a call from the Regulator than it would have two years ago.”

110% funding target

The Regulator has also set a personal measure for raising the average funding target to 110% of PPF liabilities. This means UK defined benefit schemes would have to improve their coverage ratio by about 34% on average. Such a target will be challenging to achieve given the decline in company cashflows, hampering their ability to make contributions. “We hope that this is only an internal measure that will not be applied at the individual scheme level,” notes Banks. “For some schemes, it would be a very conservative target well beyond the level of a buyout.”

In addition, the use of AA corporate bonds as a liability discounting measure is coming under attack. The AA approach was approved in the Regulator’s last corporate plan; however, with AA corporate yields 275-300bps above gilts, the actuarial community feels it is no longer prudent for schemes to use it as the discount rate other than for accounting purposes where its use is mandated. “AA bonds are not always seen as a prudent way of measuring liabilities whereas they were three years ago when risk premiums were significantly lower.”

There are a number of reasons as to why AA-bond discount rates are not well suited for most funding purposes: there are no long-dated AA bonds in issue and current spreads are at historically high levels compared to a 20-year average spread of 125bps and five-year average of 75bps. Default risk is also perceived higher than before with insurance companies using default rates of .8% on their corporate bond portfolios. As an alternative, actuaries are using gilt yields or swap rates and adding an explicit risk premium based on the asset strategy of the pension scheme, or they are starting with AA bond yields and adjusting for the above factors.

VB