Occupational Pensioners’ Alliance

1. Occupational Pensioners’ Alliance Scheme Specific Funding Huw Evans Adrian Bourne 23 October 2008

2. Pension Scheme Funding • Stage 1 – Foundations • Stage 2 – Analysis and Decisions • Stage 3 – Putting it all together

3. Stage 1 - Foundations Legislation Code of Practice Statement of Funding Principles Balance of Powers Potential Trustee / Employer conflicts Funding process and Valuation Action Plan Sponsor Covenant Regulator Supervision

4. Stage 1 Legislation EU Directive sufficient and appropriate assets to cover the scheme’s technical provisions Pensions Act 2004 • Statutory Funding Objective = sufficient and appropriate assets to cover the technical provisions • Take account of specific characteristics of the scheme and sponsor Technical provisionsmeans the amount required, on an actuarial calculation, to make provision for the scheme’s liabilities

5. Stage 1 Code of practice • Objective assessment of employer’s covenant • Method and assumptions for technical provisions - trustees’ responsibility • Assumptions taken together should be prudent, but some risks are acceptable • Shortfall eliminated as quickly as the employer can reasonably afford

6. Stage 1 Statement of Funding Principles • Formal valuations can still be only once every three years, but need interim annual reports • Typically trustees and employers must agree a Statement of Funding Principles • Actuarial advice and guidance to the trustees (and employers) SFP: Statement of Funding Principles Employeragreement / consultation Actuarial advice • Explanation of the calculation of the Technical Provisions • Details of Recovery Plan to meet the SFO Consideration of natureand circumstances of the scheme Actuarial valuation Recovery Plan SOC: Schedule of Contributions

7. Stage 1 Balance of Powers Consult? Employer Trustees Agree? Legislation / Rules / Regulator Trustees’ Actuary Employer’s Actuary

8. Stage 1 Potential Trustee / Employer conflicts • Trustees with senior management positions • Separate advisers? • Sharing of information and confidentiality • Need for constructive dialogue with Company Code of Practice • Any conflicts of duty or interest need to be recognised as soon as possible and dealt with appropriately • Where appropriate, the Trustees should obtain legal advice as to how to manage these conflicts

9. Stage 1 Stage 1 Funding process 3. How fast shouldwe turn on the tap? 2. How should the fund be invested? Funding target Investment returns 1. How high to aim for? + Contributions Assets + Existing assets Benefits = Benefits paid

10. Stage 1 Funding considerations Recovery Period TechnicalProvisions (and other subsidiary targets) How fast do you want to get back on track when below target? Funding target Investment strategy Other forms of member security More return-seeking assets like equities would mean lower expected contributions but more risk that the actual contributions required will exceed the expected value For example, escrow arrangements or other forms of contingent funding

11. Stage 1 Practical process Meetings Responsibilities Sub- committees Action Plan Dialogue with Company Timescales

12. How and where does covenant fit in? Covenant The Regulator expects trustees to have a good understanding of the position of the scheme as an unsecured creditor of the company • Investment returns/VaR: What are the financial consequences if assumptions prove incorrect? • Recovery plans:What is the range of contributions that the sponsor can afford to make? • Technical Provisions: How might covenant strength align to confidence levels? Actuarial assumptions Investment Risks

13. Revision : What to expect of TPR under SSF- the Code of Practice Para 57 – It is essential for the Trustees to form an objective assessment of the employer’s financial position and prospects as well as its willingness to continue to fund the pension plan’s benefits (the employer’s covenant). Para 59 – The employer is obliged … to provide the trustees with such information as they … reasonably require … This includes information reasonably required to assess the employer’s covenant. Para 92 – … trustees should consider … the ability of the employer to cope with the financial consequences of assumptions not being borne out by experience. Para 101 – Trustees should aim for any shortfall to be eliminated as quickly as the employer can reasonably afford. What is possible and reasonable, however, will depend on the trustees’ assessment of the employer’s covenant. Focus on the employer covenant through out the valuation process

14. How do we assess covenant? Backward and forward looking….art not a science! How strong is the balance sheet? What is the nature of the assets therein? Insolvency outcome: What are the prospects of insolvency and an indicative outcome for the scheme? Ability to pay How profitable/cash generative is the business? And how is cash utilised? Are the trends positive? Earnings and cashflow Balance sheet Business risks What is relationship between the employer and wider group? Is there any structural subordination? Relationship covenant What are the future prospects for the company? How predictable are the earnings and cashflow? What is the default probability? ….and willingness

15. Particular focus on irrecoverable zone…. • What if the investments under perform? • At what point does the strain become to much on the covenant? • Assessment will aim to identify critical issues and when risk becomes too great

16. Monitoring the covenant! Commentary All indicators remain positive. In particular: • Gross profit has improved slightly year on year (“yoy”). • Cashflow remains strong albeit net cash levels have decreased yoy due to acquisition spending and pensions contributions. • There is also strong net cash coverage. • Similarly facilities headroom has also decreased but remains at a level that is not covenant weakening. • The ratio of net cash as % of nwc remains strong and is explained in more detail on page X. • Revenue growth is buoyed by acquisitions but importantly the gross profit margin and PBT as a % of revenue ratios have both been maintained. • Headline PBT has also improved. • Source data and explanations are set out on page [ ]. Financial statement indicators Strong Moderate Negative Weak Risk weighting Positive Cash Flow Statement Income Statement BalanceSheet Revenue growth: 25% Net cash: £246m (£391m) Net assets: £550m (£513m) Net cash coverage of deficit contrib: 2.3x Gross profit margin: 6.2% (6.2%) Facilities headroom: £641m (£785m) Net cash as % of nwc: 27.6% PBT as a % Rev : 1.3% (1.2%) Annual BBPF deficit contrib cover by h’room: 40.1x PBT : £77m (£76m) Figures in brackets represent six months to June 2007 results

17. Stage 1 Pensions Regulator’s “targets and triggers” Technical provisions Buy-out cost Unlikely to investigate further May investigate - maturity? PPF FRS17 Liabilities Very likely to investigate further

18. Pensions Regulator’s approach • Hands-off so long as they think things are moving to a conclusion • Work to bring parties together • They appears very keen to stay as a referee rather than a player

19. Stage 2 – Analysis and Decisions Establishing the funding plan Integrated funding and investment Assumptions Recovery Plan Contingent assets Buy-out

20. Stage 2 Establishing the funding strategy 3. Journey plan (balance of contributions + investment returns + risk tolerance) Funding level 1. How much? Buy-out ? ? Gilts Corporate bonds Mixed portfolio 4. Risk tolerance { Time A B C 2. By when?

21. Stage 2 Integrated Funding and Investment Trial high-level investment strategy and technical provisions Initial fundamental discussions New trial Model the future • scenario or stochastic Results unacceptable Resulting level of contributions, funding levels over time and risk Results acceptable Finalise valuation Refine investment strategy

22. Stage 2 Assumptions Financial assumptions • Pre retirement discount rate • Post retirement discount rate • Inflation • Salary increases • Pension increases Demographic assumptions • Mortality after retirement • Mortality in service • Rates of leaving service • Rates of early retirement • Rates of ill health • Promotional salary scale • Marital statistics

23. Stage 2 Fundamental questions • What is the appropriate approach to setting discount rate for the Scheme? • to assume current investment strategy maintained? • to anticipate gradual switch from equities to bonds? • to ‘match’ assets to liabilities assuming lower discount rate after retirement (bond-based) and higher discount rate before retirement (equity-based)? • What is meant by prudence? • Acknowledging that real life is variable

24. Stage 2 Mortality assumptions • Need • “base table”: a snapshot of the mortality rates expected over the year following the valuation • “improvement factors”: i.e. how mortality rates will change in future • Never enough data to be confident of either • No single “right” answer • “cohort projections” are pretty arbitrary and rather old by now • tPR guidance reflects pushback on consultation doc

25. Stage 2 Mortality beliefs Continued Acceleration Extreme Trend Reversal Medical advances continue to accelerate. As each major cause of death is reduced, resources are re-deployed to tackle the remaining causes that have become more significant as a result. As per “trend reversal”, but the pace of change in circulatory disease mortality also reduces sharply. Typical justifications tend to focus on trends in cigarette smoking and/or rising obesity levels. Trend Reversal No Future Improvements Total pace of improvement slows as deaths from heart disease and stroke become less common and other causes of death prove more difficult to eliminate. Generations born in the post-war years continue to experience less rapid improvements as lifestyle-related illness take their toll. Who can tell what’s going to happen in the future… obesity, bird flu, climate change …this whole mortality improvement thing is over-hyped

26. Stage 2 Recovery Plans “Agreed process to get back to full funding on the agreed assumptions” Factors to consider: • Strength of employer • Balance of powers • Trustees’ and Employer attitudes to risk • Financial strength of scheme • Maturity of scheme • Investment strategy • Consider buyout position • Less prudent assumptions in recovery plan? • Contingent security

27. Stage 2 Contingent Assets • Trustees may consider less stringent funding objectives and/or longer recovery periods if the Employer were to provide contingent security • Contingent security could also influence the Trustees’ thinking on investment strategy (for example may be acceptable to retain a higher proportion of equities) • Could reduce PPF levy in future (but no effect in current funding position)

28. Stage 2 How important is buy out? • Who cares about the buy out funding level? • Members and Trustees – level of benefits that would be provided if Company were to become insolvent • Actuary required to assess buy out level both now and over the next 3 years • The Pensions Regulator – likelihood of having to call on the PPF in the future • Shareholders / potential buyers – cost of extinguishing DB liabilities • Therefore you can’t ignore the buy out funding level • However…an alternative funding measure would be to concentrate on a closed fund position or self-sufficiency position based on matching investments such as bonds

29. Valuations go badly when… • Employer engages late in the process • Employer goes AWOL during process • Employer disagrees with covenant assessment

30. Valuations go badly when… • Trustees fail to position themselves for a negotiation • Trustees start with an unrealistic negotiating position

31. Valuations go badly when… • Agreements in principle are unpicked while drafting of the Statement of Funding Principles • Technical Provisions are set too high: consider other funding objectives • Conflicts are not managed properly

32. Stage 3 – Putting it all together Documentation Beyond the valuation

33. Stage 3 Documentation Recovery plan (if needed) Valuation report Contingent funding detail (if needed) Schedule of contributions

34. Stage 3 Stage 3 Beyond the valuation • Communication to members • Finalise investment position eg diversification of return-seeking assets • Review scheme options – commutation / early retirement / transfer values • Project review and lessons learnt for next time • Monitor progress against funding plan