May 2018

DB pension fundingin the charitable sector

Charities continue to face financial challenges at the moment with fundraising under pressure from GDPR changes, and contracts being run on ever tighter margins.

Welcome

Layered on top of this is an increased pensions burden, with additional regulatory scrutiny and pressure to pay off pensions deficits more quickly. We’ve analysed the Defined Benefit (DB) pension exposures of the largest 40 charities by income in England & Wales to assess the issues and how charities should respond. These charities have a combined £30bn of reserves and £12bn of annual income, and support aggregate DB liabilities of over £9bn.

Key findings

Average DB scheme funding level

Average allocation to growth assets

18% of charities have a pension surplus

58% of charities have closed their DB scheme to

future accrual

15% of charities have granted security to their DB

scheme

The average pension deficit is 22% of unrestricted

reserves

The average pension deficit is 33% of annual net unrestricted income

The average charity pays 3% of net unrestricted

income into its pension scheme

82% 53% 18% 58%

15% 22% 33% 3%

2

Alistair Russell-Smith

Partner alistair.russell-smith@hymans.co.uk

020 7082 6222

How should charities respond?1. Expect more regulatory scrutiny. High profile

pension scheme failures in recent years, such as BHS and Carillion, are leading to increased regulatory pressure to fund DB schemes whilst the employer has the capacity to do so. This is coming through in the ‘2018 Annual Funding Statement’ from the Pensions Regulator, which is a precursor to an update to the code of practice on DB funding. In addition, the Regulator has announced further scrutiny on schemes with assets of under £80m. There is a new requirement for these schemes to provide additional disclosures with the next triennial valuation submission. This is due to concerns around governance and conflicts of interest in some smaller schemes.

2. Ensure value for money on your DB contributions. If charities are agreeing to new, potentially more onerous recovery plans, consider applying conditions to ensure value for money. Examples include; revisiting long term funding targets (for example to reflect lower buy-in pricing now available or the emergence of alternative cheaper settlement solutions); improving the efficiency of your funding and investment strategy (for example using security

to support longer recovery plans, only taking the level of investment risk that is required to pay the benefits, and enabling member options); and reducing running costs (for example using an investment platform, transferring to a DB Master Trust or using a sole trustee model).

3. Keep up with sector specific multi-employer pensions developments. Consider using a ‘deferred debt arrangement’ which was introduced in April 2018 and enables charities to stop accrual in multi-employer DB schemes without having to pay an immediate Section 75 debt payment. Likewise, there is now far more flexibility in LGPS (Local Government Pension Schemes) to cease accrual without paying an upfront cessation debt. Be aware that some multi-employer schemes are changing the accounting treatment of pension liabilities and moving from recognising the present value of deficit contributions on balance sheet to full FRS102 pension reporting. This will likely increase pension liabilities on balance sheet and the pension expense in P&L. The Social Housing Pension Scheme is making this change in March 2019.

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Charity analysis

IntroductionThe ability of a charity to support its DB obligations is more important than the size of the liabilities or deficit in isolation. Our analysis therefore focuses primarily on the size of the pension scheme relative to the size of the charity, by considering the following measures:

Measure What it showsDeficit / unrestricted reserves

The level of charity assets available to potentially support the pension scheme (restricted assets and endowments are excluded as they are typically not accessible by the pension scheme)

Deficit / net unrestricted income

The level of charity income available to potentially fund the pension scheme (restricted income is excluded, and the cost of generating the unrestricted income has been removed to leave a net amount of income that could be spent on charitable activities or to fund the pension scheme)

DB pension contributions / net unrestricted income

The proportion of net unrestricted income that is paid into the pension scheme

Deficit/unrestricted reserves

ResultsThe charts below show the distribution of results on each of these measures.

40%

0%

20%

60%

80%

100%

Average deficit is 22% of unrestricted reserves

1 charity has a deficit that exceeds itsunrestricted reserves

SCF

NH

USWSU NT

CGLI

RMS

AFC

CCC

RSCPA CU

TLC

GDST

LCD

OCT

AT

CRT

ROHCG

UCSF

WC

ACE

RNLI

CGL

MH

CAF

BHF

CCE

WT

RCSB

SAH

MCS

MC

BRCCR

BC BAR

AGE

OXF

SABU

Deficit/net unrestricted income

MCS

CGL

BRC

WC

ACE

SAH

RCSB

RSPC

A

AFC BU CRT

RNLI

OXF

AGE

SA

LCD

BAR

SCF

CGLINT

NH

MH CU

TLC

ROHCG

GDST

CCC

UCSF

USW CCE

OCT

SU

RMS

BC CR

BHF

MC

AT

Average deficit is 33% of net unrestricted income

2 charities have a deficit that exceeds theirnet unrestricted income

CAF

WT

40%

0%

20%

60%

80%

100%

DB contributions/net unrestricted income

Average pension contributions are 3% of net unrestricted income

1 charity is paying more than 10% of its net unrestricted income into the pension scheme

MCS

CGL

BRC

WC

ACE

SAH

RCSB

RSPC

AAFCBU CRT

RNLI

OXF

AGE

CAF

SA

LCD

BAR

CGLI

SCF

NT

NH

MH CU

TLC

ROHCG

GDST

UCSF

USW CCE

OCT

CCCSU RMS

BC BHF

MC CR

AT

WT0%

2%

4%

6%

8%

10%

4

Code Charity Code Charity

ACE The Arts Council of England MCS MacMillan Cancer Support

AFC Action for Children MH Methodist HomesAGE Age UK NH Nuffield HealthAT Anchor Trust NT The National Trust for Places of Historic Interest or

Natural BeautyBAR Barnardo’s OCT Oasis Charitable TrustBU Bangor University OXF OxfamBC The British Council RCSB Royal Commonwealth Society for the BlindBHF British Heart Foundation RMS Royal Mencap SocietyBRC The British Red Cross Society RNLI The Royal National Lifeboat InstitutionCAF The Charities Aid Foundation ROHCG Royal Opera House Covent Gardens FoundationCCC Canterbury Christ Church University RSPCA Royal Society for the prevention of Cruelty to AnimalsCCE Church Commissioners for England SA The Salvation ArmyCGLI The City & Guilds of London Institute SAH St Andrew's HealthcareCR Cancer Research UK SCF The Save the Children FundCRT Canal & River Trust SU Swansea UniversityCU Cardiff University TLC Trustees of the London Clinic LimitedCGL Change Grow Live UCSF United Church Schools Foundation LtdGDST The Girls' Day School Trust USW University of South Wales/Prifysgol de CymruLCD Leonard Cheshire Disability WC The Woodard CorporationMC Marie Curie Cancer Care WT Wellcome Trust

Pension scheme analysis

The wellbeing of the pension scheme also provides valuable insights. The charts below show the distributions of funding level and allocations to growth assets.

Funding level

40%

60%

80%

100%

120%

Average funding level is 82%7 charities have a surplus and 1 of these has a funding level of more than 120%

CCE

BAR

USWSA NH

CRT

OXF

AGE

CU

GDST

CCC

ROHCG

OCT

TLC

UCSF

RMS

AFC CAF

CGL

LCD

AT

MH

WC

ACE

BHF

CGLI NT

RCSB

RSPC

A

SAH

MCS

MC

BRCCR

BCWT

SU SCF

RNLI BU

Growth asset proportion

0%

20%

40%

60%

80%

100%

Average allocation to growth assets is 53%Charities taking a lower level of investment risk face lower deficit volatility and can arguably fund deficits over a longer period of timeSA

H

OCT

WC

CGLI BC

UCSFNH

ROHCG

SCF

CU

CRT

CGL

OXF

MH

LCD

NT

RNLI

RSPC

A

BHF

RCSB

RMS

AGE

SUAFCCR

WT

TLC

MCS

MC

BRC

CAF

ACE

CCC

BAR

USW BUAT

GDST

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1) Expect more regulatory scrutinyThree years ago the regulatory focus was on balancing the sustainability of employers with the security of members’ benefits. However, off the back of recent high profile corporate failures (most notably BHS and Carillon), the emphasis has switched to paying off deficits whilst the employer has the means to do so. The growing gap between dividend levels and pension contributions is a particular area of focus. The Regulator’s 2018 annual funding statement pushes pension scheme trustees to increase funding targets and shorten recovery periods.

Separately, schemes with assets of under £80m can expect increased scrutiny from the Regulator at their next triennial valuation. The Regulator is particularly concerned with governance and conflicts of interest in these smaller schemes. Schemes will need to complete an additional set of disclosures with the submission of their next triennial valuation. 35% of charities in this survey can expect this additional disclosure requirement.

Charities can sometimes have significant levels of reserves or unencumbered assets. They arguably do therefore fall into the category of being able to fund deficits quicker. Charities should therefore expect more regulatory scrutiny this year, and ensure robust funding strategies with contingency plans are in place.

2) Ensure value for money on your DB contributionsThe need to revisit recovery plans at the next valuation and potentially agree more onerous plans, means charities should ensure they get value for money from these contributions. Examples of conditions that can be agreed alongside deficit contributions include:

1. Revisit long term funding targets. DB settlement is becoming cheaper (relative to gilt yields), with attractive annuity pricing and the emergence of alternative cheaper settlement solutions. A lower long term funding target may now be appropriate. Two new settlement solutions that could be considered include:

Non-insured risk transfer. This transfers scheme assets and liabilities to another pension scheme that is outside the insurance regime but backed by external capital. It is materially cheaper than buy-out. It may be appropriate for charities that cannot afford full buy-out, but could afford a significant contribution into their scheme. This is because it then gives the charity a clean break and leads to an improvement in covenant for scheme members. Insured self-sufficiency. This transfers scheme assets and liabilities to an insurer which then runs the scheme off with its own backbook and targets full buy-out over time. It is therefore also cheaper than immediate buy-out. All risk other than downside tail risk is passed to the insurer.

2. Improve the efficiency of your funding and investment strategy. Options include:

Use security to support a longer recovery plan. 15% of charities in this survey already provide security to their schemes, and this is likely to become more common. It is an efficient way for charities with unencumbered assets to reduce cash costs and improve security for schemes. A charge over property, or transferring charity property to an SPV jointly owned by the pension scheme, are the most common approaches. However, conditional funding agreements can also be used (for example a commitment to pay further contributions if the deficit exceeds a particular proportion of unrestricted reserves, or a commitment to share proceeds from property sales or unbudgeted legacy income with the pension scheme).

How should charities respond?

1.1

2.1

1.2

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Only take the level of investment risk required to pay the benefits. Charities still have 53% of assets in growth assets. A better approach is generally to take a lower level of investment risk and hold that on for a longer period of time. This reduces the risk of having to pay more in the future, and remains appropriate if backed by the covenant or security. Enable member options. Embrace the 2015 pension freedoms by ensuring members understand their option to transfer from DB to DC. Provide supporting education or advice to ensure members make effective decisions, and to reduce the risk of member challenge.

3. Reduce running costs. As schemes get better funded and reduce risk, it becomes increasingly important to run them off as efficiently as possible. Ways to do this include:

Use an investment platform. These are being developed and allow schemes to access lower fund management charges that are negotiated by the investment platforms. This can typically reduce fund management charges by 10-20%.

Transfer to a DB Master Trust. This halves running costs as the Master Trust passes on savings from economies of scale from running multiple schemes. Running a ‘winding-up lump sum’ exercise as part of the transfer also settles small liabilities cost effectively and typically more than offsets the implementation costs. Use a sole trustee model. Pension trustee boards can be replaced by a sole professional trustee. This can enable quicker decision making and reduces running costs (for example quarterly trustee meetings are no longer required). Some sole trustees have also negotiated terms with preferred service providers which can lead to further cost reductions.

3) Keep up with sector specific multi-employer pension developmentsMany charities participate in multi-employer pension schemes, including the LGPS, the Pensions Trust (including the Social Housing Pension Scheme), and USS (Universities Superannuation Scheme). There have been a range of developments in these schemes which you should consider:

Use a ‘deferred debt arrangement.’ This has been introduced from April 2018, and enables charities to stop accrual in occupational multi-employer DB schemes without having to pay an immediate Section 75 debt payment. Some schemes already had arrangements in place to help with this (for example a separate DC section), but any charities still letting DB liabilities accrue for fear of triggering a Section 75 debt should revisit this now.

Plan for a managed exit from LGPS. LGPS funds are now more flexible with cessation debts, and it is becoming increasingly common to agree to spread debts or to cease accrual and carry on funding on an ongoing basis. Any charities continuing to let LGPS liabilities accrue for fear of triggering a cessation debt should revisit this now.

Watch for a change in accounting treatment. Some multi-employer schemes are changing the accounting treatment of pensions liabilities, and moving from recognising the present value of deficit contributions on balance sheet to full FRS102 pension reporting. This can increase pension liabilities on balance sheet and the pension expense in P&L. The Social Housing Pension Scheme is making this change in March 2019.

2.2

2.3

3.1

3.2

3.3

1

2

3

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Appendix – methodology

1. The charities analysed are the largest 40 by income in England & Wales (as listed by the Charity Commission website) at February 2018. Charities that have no DB exposure (or only participate in public sector schemes and account on a cash basis for DB liabilities) have been excluded. Lloyd’s Register Foundation is excluded as the charity is the parent of a large trading company.

2. All information has been sourced from the most recently available annual reports and financial statements as published on 1 February 2018.

3. Group / consolidated accounts have been used rather than charity accounts where relevant.

4. Unrestricted reserves and income are considered on the basis that these are potentially available to support or fund the pension scheme. Restricted reserves and income and any endowment funds are excluded on the basis that a pension scheme would not have access to them, other than where the relevant charity accounts explicitly suggest otherwise.

5. Unrestricted reserves are prior to the deduction of any pension deficit.

Please note the value of investments, and income from them, may fall as well as rise. This includes but is not limited to equities, government or corporate bonds, and property, whether held directly or in a pooled or collective investment vehicle. Further, investments in developing or emerging markets may be more volatile and less marketable than in mature markets. Exchange rates may also affect the value of an investment. As a result, an investor may not get back the amount originally invested. Past performance is not necessarily a guide to future performance.

Whilst all reasonable care has been taken in the preparation of this publication no liability is accepted under any circumstances by Hymans Robertson LLP for any loss or damage occurring as a result of reliance on any statement, opinion or any error or omission contained herein. Any statement or opinion expressed reflects our general understanding of current or proposed legislation and regulation, which may change without notice. The content of this document should not be construed as advice and should not be regarded as a substitute for specific advice in relation to the matters addressed. Please note that Hymans Robertson LLP are not qualified to give legal advice and recommend you seek legal advice to consider the matters addressed where relevant.

Hymans Robertson LLP is authorised and regulated by the Financial Conduct Authority and Licensed by the Institute and Faculty of Actuaries for a range of investment business activities. A member of Abelica Global. © Hymans Robertson LLP. Hymans Robertson uses FSC approved paper. 4861/MKT/Inf1216

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6. Net unrestricted income has been considered because this is the amount of income that could be spent on charitable activities or could be used to fund the pension scheme. This therefore excludes any restricted income or endowments and is net of the costs of generating that unrestricted income. This measure will be crude in some cases, in particular for charities whose charitable activities include running contracts, as the expense to deliver these contracts must be incurred to generate the associated unrestricted income in the first place.

7. For charities with a DB surplus, the surplus is shown prior to any balance sheet restriction. The introduction of FRS102 means that surpluses can often be recognised on balance sheet when this was not possible under FRS17.

8. DB contributions do include future service contributions (where applicable) as well as deficit contributions.

9. Some charities have significant scheme assets allocated to ‘other.’ In these cases we have tried to allocate these to growth or matching as appropriate using other information in the accounts, but this has required some judgement and may not always be correct.