A difficult year: 2020 valuations

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Trustees of schemes undergoing triennial valuations this year will be in the unenviable position of having to work with uncertain assumptions and new regulatory expectations. Here is what they should be aware of. 
Covid-19 has arguably been a black swan event, and it is continuing to have profound impacts on the economy and capital markets. Amid a lack of visibility on covenant strength, investments and longevity, trustees are having to agree numbers on all of these to declare how well their scheme is doing. 

Brexit is back with a vengeance 

Covenant will be a particular concern for trustees depending on the sector into which the sponsoring employer falls – there is a lot of variance. “Some are back to business as usual, others are still in survival mode,” says Charles Ward, a professional trustee at Dalriada – noting that he has been involved in three company voluntary arrangements over the last month “where they’re not coming out the other side”. 
Added to this is the fact – prominent in the news recently – that Britain might still leave the EU without a deal, which could hit some companies hard, for example those relying heavily on imports from or exports to the EU. 
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Pension funds can do two things now, says Ward. One of them is to revisit the work they have done about Brexit’s impact on the sponsor covenant and restart conversations with the employer.  
“We know where are now, we are coming out of the EU at the end of the year, potentially with no deal. It's understanding and engaging with the business about what that does,” he says.  
Given these pressures from the pandemic and Brexit, Ward would like to see TPR be more situation specific on valuations and covenant. “There is such a wide variety of what happened this year, a more bespoke approach is needed,” he says, arguing that some businesses could suffer from suppressed earnings “but in two years should come roaring back”. 

Check what you can do about investments 

The other thing trustees can do now is to look at their investment strategy, he adds, seeing if there is “anything defensive that needs to be done or should be done that protects against negative the impact” of a possible no-deal outcome. “What we are seeing is schemes diversifying away from equities towards contractual income assets, private debt, to get returns that approach equities but in a different form,” he adds. 
However, Ward admits that the impact is “broad-based” and therefore difficult to assess. And while Brexit is unlikely to influence global capital markets, it could rock domestic and European markets and send sterling tumbling, as it did in 2016, which boosted holdings in overseas currencies. 
Investments will play a key role in 2020 valuations, agrees Louisa Taylor, partner at XPS Pensions Group, particularly as there has been a recent deterioration after markets rebounded over the summer. And although actuaries can allow for experience before signing off on valuations, “it does depend on how investments fared since then”, she says. “If there is improvement, then trustees are able to take this into account,” but of course “it could worsen as well”. 

Should you already take the DB code into account? 

Apart from investments, covenant remains key, particularly given the reduced visibility even over the short and medium term, because of Covid-19 and Brexit. 
The fact that covenant will play such a critical role this year is why, in her view, “TPR said its thinking on the DB code has not changed”, despite various industry figures calling for a softer approach to ease pressure on employers during the coronavirus pandemic. 
The new DB funding code, on which a first consultation was issued in early March, will not be in force until the end of 2021 at the earliest, but trustees are likely to start aligning their valuations with the code already. In the new code, TPR proposes a dual approach, where schemes can either choose a ‘fast track’ option – simple qualitative and quantitative compliance tests – or a ‘bespoke’ route, which allows more flexibility, but which will also attract more scrutiny. To ensure affordability and employer cash flow is not compromised, TPR has previously said it wants to encourage greater use of contingent assets. 
“The regulator has issued quite a lot of correspondence setting out its views and principles, [and the] pension schemes bill requires schemes to have a long-term objective,” Taylor highlights, adding: “We expect trustees to be taking that into account for valuations now because we know that’s what the regulator is expecting.” Schemes might want to apply the fast track framework also to see if they are behind or ahead on this. 
The regulator has previously indicated it had become increasingly concerned that trustees and employers build in long-term views on the covenant strength; in the draft code, it said the timeframe for making assumptions about a company’s prospects does not stretch beyond three to five years. 
For the fast track route, TPR has therefore proposed to integrate only medium-term covenant visibility into technical provisions. “To the extent that trustees want to place full reliance on employer covenant beyond this typical period, we would expect such reliance to be justified under the Bespoke framework with trustees’ analysis,” it added. 

RPI reform further complicates valuations 

Just to make things even more complicated, the government has also announced it wants to bring the retail price index in line with the consumer price index including owner occupiers’ housing costs. This will affect both liabilities and assets of DB schemes to varying degrees, as it will reduce the income schemes can expect from index-linked gilts, as well as reducing any RPI-linked liabilities. 
Given the uncertainty on investments and covenant, Taylor recommends trustees use scenario analysis as it is “something the regulator is keen for trustees to understand”. This could include not only different investment but also longevity scenarios, as life expectancy is linked to how wealthy people are – which in turn partly depends on how well the economy is doing. “Where investments might deteriorate in an economic crisis, we might see falls in life expectancy that might offset some of the falls in funding position,” she predicts. 

How will this year’s valuations differ?
Charles Ward