UK DB schemes set to take 12 years to reach full funding

UK defined benefit (DB) pension schemes could take over a decade to reach full funding under new regulatory rules, despite scheme deficits against long-term funding targets falling by £40bn over the year to 31 August 2021, analysis from XPS Pensions has found.

XPS's DB UK Funding Watch estimated that despite this improvement, it will take 12 years to reach long-term targets under the proposed new rules from The Pensions Regulator (TPR), based on the combination of investment returns and current cash contributions.

The firm noted that this is slightly ahead of the timeframe by which cashflows peak and schemes are estimated to be ‘significantly mature’, a measure that TPR has indicated it will use as part of its proposed changes to the scheme funding regime.

However, it also found that if employers were to maintain paying contributions this term would be reduced to seven years, although this would require additional contributions of around £80bn.

Considering this, XPS suggested that employers and trustees may also reconsider investment strategies, contingent support and member option exercises as an alternative to cash to mitigate the impact.

The tracker revealed that the average funding level of UK pension schemes on a long-term target basis was 86 per cent as of 31 August 2021, based on assets of £1,915bn in assets and £2,230bn in liabilities.

The fall on liabilities was attributed to a 0.2 per cent fall in yields on gilts over the past year, and XPS noted that schemes that have hedged their assets to protect against falling gilt yields would have been protected from the market turmoil at the height of the pandemic, but may not have seen improvements in funding levels since.

XPS senior investment consultant, Felix Currell, commented: “Pension schemes have continued to benefit from strong equity markets, which have generally managed to shrug off concerns over new Covid variants.

“With the Organisation of Economic Co-operation and Development (OECD) revising up its economic growth forecast for 20211 that optimism is set to continue.

"However, concerns remain over the prospect of increasing inflation, a tighter labour market and increasing input costs, which has led to XPS reducing our central investment return expectations. So pension schemes will be relying on the health of the wider economy to reduce the time taken to reach their targets.”

XPS senior consultant, Charlotte Jones, added: “TPR encourages schemes to set a long-term funding target. This is seen to be good practice and will help schemes prepare to comply with the requirements of the Pension Schemes Act 2021.

“Schemes will need to work with their sponsors over the coming months to agree an appropriate target and how they plan to achieve it, whilst working collaboratively to balance the targeted level of investment returns versus any increase in cash funding.

"As an alternative, we may see employers and trustees reconsider investment strategies, contingent support and member option exercises as an alternative to cash to mitigate the impact.”

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