The European Insurance and Occupational Pensions Authority (“EIOPA”) released the results of their Europe wide Occupational Pensions Stress Test last week.
The results show that pension scheme deficits can have a detrimental impact on the economy as a whole when companies’ future growth prospects are restricted by the level of contributions that they need to pay to schemes to plug their deficits. Businesses can fail as a result, bringing unemployment.
In this situation, it is also likely that members will not receive their full benefit entitlement in retirement.
What do the results of the stress test tell us?
The UK was one of three countries that showed a funding deficit on their current funding basis. It was also the worst performing country when measured using EIOPA’s common balance sheet approach, a method that broadly measures the ability of the scheme to sustain itself. The UK also fared the worst under the stressed scenario. This showed a funding level of just 45% for UK schemes.
EIOPA estimates that sponsors would only be able to cover 80%-90% of this deficit, meaning that the remaining 10%-20% of the deficit would fall on the PPF and the reductions in the level of benefits that members receive under the PPF than their scheme.
The report also highlighted the size of deficits relative to scheme sponsors. For 25% of schemes, the estimate of value of contributions required by the sponsor in the balance sheet exceeds 42% of the sponsors’ market value. This rises to 66% when the stresses are applied. For many schemes, the value placed on sponsor support in the balance sheet is greater than the sponsors’ market value as a business.
Such high level of contributions required would likely place a huge strain on scheme sponsors. This could affect their ability to continue to trade and when considered on a national basis could have a detrimental impact on economic growth and employment.
How do we plug this deficit?
There is no magic solution to fixing the UK’s pension funding shortfall. It will likely be a long process that will take into account a number of factors including scheme funding, investment and sponsor covenant within an integrated risk management framework.
The most important of these factors is to ensure that the trustee board has the expertise to be able to monitor and understand the funding position of the scheme.
There are a number of key take-away points for trustees:
- Ensure that you monitor your scheme’s funding level closely. These can be used to enhance your understanding of your scheme’s funding volatility.
- Trustees should work closely with the sponsors of their schemes to develop funding plans that will ensure the security of members’ benefits and minimise the impact on the sponsors business.
- It is important to take care when setting and reviewing your scheme’s investment strategy. Techniques such as stress testing and stochastic modelling can be used to assess how robust the strategy is under adverse market conditions.
- Make sure to review governance procedures regularly to ensure that decision making is effective and allows the scheme to react quickly to a volatile and changing market.
- Trustees can consider other options to secure members’ benefits such as securing benefits with an insurance company. Alternatively, they can look at options that can provide members more flexibility to take their benefits whilst removing risk from the scheme. This may include giving members the option to transfer their benefits prior to retirement so they can avail of flexible drawdown options.