Valuations and recovery plans of UK defined benefit (DB) and hybrid pension schemes.

## Overview

This is the 2019 update to The Pensions Regulator’s (TPR’s) annual funding statistics for UK defined benefit (DB) and hybrid schemes. The tables in the annex are prepared in accordance with the UK code of practice for official statistics. The underlying data are sourced from valuations and recovery plans submitted to TPR by schemes with deficit positions, and from annual scheme returns for schemes with surplus positions.

The update is based on Tranche 12 schemes (with effective valuation dates falling from 22 September 2016 to 21 September 2017 inclusive). These valuations (with due dates for receipt falling within the period December 2017 to December 2018) fall within the fourth triennial cycle of scheme funding.

The report shows funding trends in the context of market conditions, assumptions and scheme characteristics that impact on valuations. It also describes reported arrangements for recovery plans, employer contributions and contingent security. Data summaries (tables) contained in the Annex provide more detail on the high-level trends presented in this document.

## Tranche 12 summary

By the end of January 2019, we had received over 1,880 valuations with an effective valuation date for Tranche 12 - just under a quarter (23%) of which reported a surplus on the Technical Provisions (TPs) funding basis. Of schemes submitting these valuations, 77.6% had previously submitted valuations in respect of Tranches 9, 6, and 3.

The growth in assets matched the growth in liabilities between Tranche 9 and 12 valuation dates for many schemes, resulting in a relatively unchanged average^{[1]} funding ratio on a TPs basis. Compared to Tranche 9, average annual deficit reduction contributions (DRCs) as a proportion of TPs for Tranche 12 are relatively unchanged, at the median in nominal terms. The relative increase in average annual DRCs is 18% at the median, while the average (median) extension to the recovery plan end date is around two years.

Figure 1 illustrates the distribution of changes in deficits measured on a TPs basis for Tranche 12 schemes that previously submitted Tranche 9 valuations. Both assets and TPs grew by 29% at the median. More than half of schemes saw a deterioration in deficits over the intervaluation period.

### Figure 1: Distribution of the change in deficits from Tranche 9 to Tranche 12

Distributions are trimmed at the 5th and 95th percentiles

Source: TPR

### Key figures at a glance

- 23% of schemes in surplus
- 109.3%: average ratio of assets to TPs for schemes in surplus
- 88.5%: average ratio of assets to TPs for schemes in deficit and surplus
- 7.3 (6.5) years: average (median) RP length for schemes in deficit
- 2.75%: average nominal single effective discount rate (SEDR) for Tranche 12 schemes in deficit and surplus; with 50% of assumptions falling on or between 2.26% and 3.18%
- -0.67%: average real SEDR for schemes in deficit and surplus; with 50% of assumptions falling on or between -1.11% and -0.29%
- 89.3 (91.2) years: median life expectancy of a future male (female) pensioner currently aged 45 for schemes in deficit and surplus

## Market conditions

During the inter-valuation period (ie between Tranches 9 and 12), growth in the UK economy declined from a post financial crisis peak in 2014. Equity markets generally performed positively over the same period. Relative to 31 March 2017 (the effective date of many Tranche 12 valuations), the FTSE All-Share Index realised a three-year and five-year total return of around 25% and 59% respectively^{[2]}.

Between Tranche 9 and Tranche 12 valuations, yields on corporate and government bonds continued on a declining trend, dipping at the start of the Tranche 12 valuation window, with market expectations for future interest rates being revised downward. The real 20-year spot rate of interest, already in the region of negative yields during the previous valuation period, remained below -1.5% towards the end of the Tranche 12 valuation period.

Figure 2 shows market expectations for real interest rates as estimated by the Bank of England in the inter-valuation period. Forward interest rates at the end of March 2017 show an expectation for lower yields over all maturities relative to the position a year earlier and in March 2014.

### Figure 2: UK instantaneous real forward curve

Source: Bank of England

## Deficits

Like the previous tranche in Cycle 4, Tranche 12 schemes have seen improved asset positions, which may have been due to the combined impact of:

- sponsor contributions (regular and remedial), and
- positive (overall) gains on investments in the three years to valuation

Liabilities have also grown due, in part, to lower investment return assumptions relative to those assumed in the previous valuation - which in turn may have been driven by revised (lower) expectations for long-dated bond yields relative to Tranche 9 valuations. In general, schemes with hedged positions in respect of interest rate risk will have fared better overall.

- 109.3%: average ratio of assets to TPs for schemes in surplus.
- 88.5%: average ratio of assets to TPs for schemes in deficit and surplus.

For schemes submitting valuations in respect of both Tranche 9 and Tranche 12, the median increase in both assets and TPs between valuations is 29%. The average ratio of assets to TPs for Tranche 12 is 88.5% (90.3% weighted^{[3]}), a -0.9 percentage point deterioration on the average for Tranche 9. The average ratio is generally higher for schemes:

- that report liabilities in respect of active memberships
- with stronger covenants (deficit schemes only)
- without a contingent asset
- with shorter recovery plans

Additionally, the average funding ratio meets or exceeds 90% for:

- the most mature schemes (pensioner liabilities that represent 75% or greater of total liabilities)
- the largest schemes (by both liabilities and members) and
- schemes with the most conservative investment strategies (less than 20% of assets invested in return-seeking investments).

See Tables 2.1 and 2.3(b) in the Annex

For schemes in surplus only, the average ratio of assets to TPs is 109% (107% weighted).

Relatively higher funding among schemes reporting TPs in respect of active members, could reflect that less well-funded schemes are more likely to close to future accruals.

Figure 3 shows the distribution of the ratio of TPs to buyout liabilities for Tranche 12 schemes in deficit by covenant group^{[4]}, and the proportion of pensioner liabilities.

Generally, the ratio of TPs to buyout liabilities levels is lower for schemes with stronger employers. This may reflect that schemes with weaker employers incorporate greater prudence in valuation assumptions. For any given covenant group, more mature schemes (ie with a higher proportion of pensioner liabilities to total liabilities) have a higher ratio of TPs to buyout liabilities than less mature schemes. This trend is least pronounced for schemes in covenant group 1, although the difference between schemes in the lowest two maturity brackets differs little for any covenant group.

### Figure 3: Ratio of TPs to buyout Liabilities for Tranche 12 by covenant and maturity - schemes in deficit only

Source: TPR

## Funding strategies

### Recovery plans

For some schemes, a smaller deficit has led to a shortened recovery plan relative to that agreed under the Tranche 9 valuation.

Figure 4 shows the distribution of changes to recovery plan end dates for Tranche 12 schemes that had previously submitted Tranche 9 valuations. Just under half of schemes (including those which remain in surplus) have brought forward their recovery plan end dates or have left them unchanged, while around one tenth have extended their recovery plan end dates by more than six years.

### Figure 4: Distribution of changes to recovery plan end dates

Source: TPR

### Median recovery plan end dates

- 2017 (Tranche 3)
- 2019 (Tranche 6)
- 2022 (Tranche 9)
- 2024 (Tranche 12)

In respect of their first valuations under scheme specific funding, schemes in the Tranche 3/6/9/12 cohort had a median recovery plan end date falling in 2017. Under the fourth cycle of funding the same schemes have a median recovery plan end date falling in 2024.

Reflecting challenging market conditions, the mean and median recovery plan lengths for Tranche 12 are 7.3 years and 6.5 years respectively. Tranche 12 recovery plan end dates exceed those of Tranche 9 by 2 years at the median. Longer plans tend to be associated with schemes:

- with weaker covenant support
^{[5]}, and - with a greater allocation to return-seeking assets (which may reflect de-risking among schemes with better funding/relatively shorter recovery plans)

See Tables 3.1 and 3.3 in the Annex

Figure 5 shows the distribution of recovery plan lengths for Tranche 12 schemes by covenant group^{[6]}. Three quarters of schemes in covenant group 1 have recovery plans of at most eight years, while the same proportion of schemes in covenant group 4 have recovery plans of up to 13 years.

### Figure 5: Distribution of recovery plan length by covenant (Tranche 12)

Distributions are trimmed at the 5th and 9th percentiles.

Source: TPR

The median extension to the recovery plan end date for schemes migrating from covenant group 2 to covenant group 4 over the inter-valuation period is two years (see: Table 1). Generally, an improvement in covenant for weaker schemes is associated with a smaller extension to recovery plans compared with that under a static transition or a weakening of covenant.

### Table 1: Median recovery plan end date extension by covenant group migration (Tranche 12 schemes in deficit only)

Median recovery plan end date extension (years) |
||||

Covenant Group (Tranche 12) |
||||

Covenant Group (Tranche 9) | 1 | 2 | 3 | 4 |
---|---|---|---|---|

1 | 1.3 | 2.7 | 3.8 | N/A |

2 | 2.9 | 2.0 | 1.7 | 2.0 |

3 | N/A | 0.0 | 2.1 | 1.8 |

4 | N/A | 0.3 | 2.0 | 1.8 |

Source: TPR

### Contributions

For schemes in deficit with valuations in respect of both Tranches 9 and 12, average annual DRCs increased (in nominal terms) at the median.

As a proportion of liabilities calculated on a TPs basis, average annual DRCs for Tranche 12 schemes are relatively unchanged at 2.1% compared to 2.2% for Tranche 9 schemes at the median.

This is influenced by increases in liabilities calculated on a TPs basis, as well as changes in nominal DRCs. The median increase in TPs is 29% and the corresponding relative increase in average annual DRCs is 18%. A higher level of DRCs as a percentage of liabilities on a TPs basis is associated with:

- shorter recovery plans
- smaller schemes (by both TPs and members)
- lower maturity (schemes with pensioner liabilities that are less than 25% of total liabilities)
- schemes with a lower ratio of assets to TPs and
- schemes with a less than 20% allocation to return seeking assets

Figure 6 shows the extent to which the percentage point increase in average annual DRCs as a proportion of TPs varies by the percentage point increase in TPs funding for Tranche 12 schemes in deficit. It can be seen that the majority of schemes with positive increases in funding ratios from Tranche 9 to 12 have increases to average annual DRCs as a proportion of liabilities that are concentrated in the range: -1% to 0.5%.

Schemes with a negative increase in the funding ratio have increases to the average annual DRCs as a proportion of liabilities that are concentrated in the range: -0.5 to 1%. The level of DRCs will be influenced by extensions made to recovery end dates (two years at the median) as well as changes to the size of deficits.

### Figure 6: % (Absolute) increase in DRCs as a proportion of TP liabilities vs. % (Absolute) increase in the ratio of assets to TPs (schemes in deficit only)

Source: TPR

### Assets

The majority of Tranche 12 schemes have less than 60% of assets invested in return-seeking^{[7]} asset classes, while around a quarter of schemes have a higher allocation to riskier assets.

Among Tranche 12 schemes there is little evidence of a greater prevalence of riskier investments among schemes with a stronger covenant. This could be because schemes with stronger covenants tend to be better funded, and better funded schemes may be more likely to afford (and hence adopt) de-risking strategies.

Figure 7 shows the distribution of return-seeking assets by covenant group and maturity for schemes in deficit. For all covenant groups, the scheme’s allocation to riskier investments is linked to maturity. The median allocation to return-seeking assets is 47% for covenant group 2 schemes with pensioner liabilities that are less than 25% of total liabilities, compared to 20% for covenant group 2 schemes with pensioner liabilities that are 75% or a greater proportion of total liabilities.

### Figure 7: Distribution of return-seeking assets by covenant group and maturity

Source: TPR

### Contingent security

Less than a fifth of Tranche 12 schemes have additional security in the form of one or more contingent assets, which typically, but not always, takes the form of guarantees from a sponsor’s parent or associated entity.

Less than a tenth of schemes have contingent assets that are formally recognised by the PPF in the calculation of the PPF risk-based levy. A similar proportion have contingent assets that are not recognised by the PPF but are reported as additional security in support of funding. The presence of contingent assets is associated with:

- larger schemes and
- weaker covenant support

## Valuation assumptions

### Discount rates

Market experience and changing expectations over the inter-valuation period may be reflected in discount rates to varying degrees - depending on investment strategy and/or valuation approach. The statistics show an association between the TP’s discount rate and a scheme’s investment strategy. (The investment strategy of a scheme is approximated here by the scheme’s allocation to return-seeking assets and may itself take some account of the ability of the employer to underwrite downside risk).

Between Tranche 9 and Tranche 12 valuations, the 20-year nominal spot rate on gilts declined overall. Near the end of the Tranche 12 valuation period it had reached a 10 year low. The gap between implied inflation and the nominal gilt yield, which had widened during the Tranche 11 valuation period, widened yet further - keeping real yields negative over the Tranche 12 valuation period.

For 31 December 2016 and 31 March 2017 (the two most common Tranche 12 valuation dates), the 20-year spot rates are 1.93% and 1.83% respectively, while the corresponding median single effective discount rates (SEDR) for valuations are 2.75% and 2.61% respectively. The median SEDR fell below the rate of 20-year market implied inflation, relative to the position a year earlier.

Figure 8 shows the median SEDR relative to 20-year UK gilts, 20-year spot inflation, and greater than 15-year AA-rated corporate bonds (for schemes in deficit in Tranches 1 to 7 and for all schemes in Tranches 8 to 12).

### Figure 8: Median (nominal) SEDR, Bank of England nominal 20-year spot rate, greater than 15-year AA corporate bonds, and 20-year inflation

Sources: TPR, Thomson Reuters, Bank of England, Markit iBoxx

The average real SEDR is -0.67% for Tranche 12, compared to 0.92% for Tranche 9.

Schemes with a higher proportion of return-seeking assets tend, on average, to assume a higher discount rate. The implied level of outperformance over gilts in the discount rate appears to have an even stronger relationship to the proportion of return-seeking assets held by schemes - although there is a wide range of assumptions in discount rate outperformance among schemes with a similar allocation to return-seeking assets.

The average assumed return over nominal gilts is marginally lower for Tranche 12, compared to Tranche 9. However, the average outperformance of the real SEDR over the 20-year real government spot rate is 1.07% for Tranche 12, compared to 0.89% for Tranche 9.

### Life expectancies

While there were notable increases in average assumed life expectancies over the first three funding cycles, reflecting stronger mortality assumptions over that period, assumptions regarding average life expectancy improvements are generally lower for Tranche 12 schemes relative to Tranches 9 and 6, for both future and current pensioners.

This reflects the general trend observed in the wider population over the last few years and that almost all schemes use the CMI mortality projection model when allowing for future improvements.

The average assumed life expectancy for a current male pensioner aged 65 is 87.6 years (compared to 87.9 years in Tranche 9). In respect of the underlying mortality assumptions:

- 96% of Tranche 12 schemes use the SAPS tables
- 52% apply a scaling factor or rating to base tables to adjust for scheme experience
- 96% use the continuous mortality investigation (CMI) projection model (first published in 2009) to allow for future improvements
- while 83% of schemes assume a long-term rate of improvement/underpin of 1.5% or higher with 7% assuming a rate of 2% or higher

Figures 9a and 9b show the distribution of assumed life expectancies for future pensioners aged 45 (male and female) respectively, for Tranches 3, 6, 9 and 12. At the median, the assumed life expectancy of a future male pensioner currently aged 45 for Tranches 9 and 12 is 89.9 and 89.3 years, respectively. Similarly, the median life expectancy of a future female pensioner currently aged 45 for Tranches 9 and 12 is 92.1 and 91.2 years respectively. The median life expectancy assumption for future pensioner males (females) in Tranche 12 is higher than the corresponding assumption for Tranche 3 by around 0.3 years (-0.1 years).

### Figure 9a: Distribution of life expectancy assumptions for future female pensioners currently aged 45 (Tranches 3, 6, 9, 12)

Source: TPR

### Figure 9b: Distribution of life expectancy assumptions for future male pensioners currently aged 45 (Tranches 3, 6, 9, 12)

Source: TPR

## Footnotes

- [1] Averages are unweighted unless stated otherwise
- [2] FTSE Russell Factsheet (31 March 2017)
- [3] Weighted by TPs
- [4] Defined as: 1 (strong), 2 (tending to strong), 3 (tending to weak), and 4 (weak)
- [5] Based on covenant group
- [6] Based on covenant group
- [7] ‘Return-seeking assets’ in this report include equities, commodities, 60% of insurance policies, 75% of property, 80% of hedge funds, 25% of corporate bonds and assets held in the ‘other’ category