South East Water Limited. Pensions support for PR14 price review process. 14 October 2013

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1 South East Water Limited Pensions support for PR14 price review process 14 October 2013

2 Scope and Purpose This report contains factual information on the background and development of the South East Water Pension Scheme and the Mid Kent Group Pension Scheme over the period from 2008 to It has been prepared by KPMG as South East Water s corporate pensions adviser and has been produced to assist South East Water in preparing its submission to Ofwat for the PR14 price review. The sources of all data and evidence are included and the information has been obtained to the best of our ability with appropriate sources suitably referenced. KPMG LLP have produced this paper to supplement South East Water Limited s ( the Company s ) Ofwat submission for the PR14 price review process. The paper is produced solely for the Company s benefit and may not be shared or relied upon by any other party unless informed in writing by KPMG LLP. The paper may be shared with Ofwat as part of the Company s submission on a non-reliance basis. This report is compliant with the relevant Technical Actuarial Standards (TASs) in force published by the Financial Reporting Council. In particular Pension TAS and the TASs for Reporting Actuarial Information, Data and Modelling have been followed so far as their requirements are material to this work. Background of the Schemes Overview of the structure of South East Water s two funded DB pension schemes and the DC pension scheme Pensions developments over AMP5 Commentary on general market trends, development of markets, economic indicators and demographic trends Description of scheme specific changes Closure to future accrual of benefits Change of deferred revaluation linking from RPI to CPI 2011 actuarial valuation outcome Introduction of option to exchange increasing pension for fixed pension at retirement Triggered de-risking of the investment strategy Pension costs over AMP6 Estimated financial position of the plans as at 31 March 2013 Estimates of future cash requirements Analysis of financial risks around future cashflows over the period to the actuarial valuation as at 31 March 2014 Estimated impact of auto-enrolment on pension costs Projections of cost over AMP6 and AMP7 Benchmarking of the 2011 actuarial valuation assumptions against other water companies and the market more generally Commentary on anticipated external changes, for example pensions regulatory changes 1

3 Contents The contacts at KPMG in connection with this report are: Linda Ellett Partner Tel: Page Executive summary 3 Relevant background to the pension schemes 4 The 2011 Scheme Funding valuations Summary 6 Progression of the deficit 7 Benchmarking key assumptions 8 9 Jonathan Green Senior manager Tel: Aled Davies Senior manager Tel: Financial market trends 10 Demographic trends 11 RPI to CPI revaluation 12 Actions taken to reduce cost and risk since 2011 valuations Closure of the Schemes to the future accrual of benefits 14 Changes to pension increases 15 Implementation of de-risking triggers for the Schemes 16 Projected pension costs over AMP6 and AMP7 Projected future deficit contributions 18 Projected cost of future pension accrual Anticipated external changes 21 Summary of pensions de-risking strategies past and future 22 Appendices 23 2

4 Executive summary The 2011 Scheme Funding valuations Changes to the Schemes since the 2011 valuations Projected pension costs over AMP6 and AMP7 Between the Scheme Funding valuations at 31 March 2008 and 31 March 2011 the deficits in the Schemes increased from 52.4 million to 60.4 million. This increase arose despite: c. 14 million of deficit contributions being paid in by the Company, and A further reduction of 14 million in the liabilities when the Schemes adopted the Consumer Price Index (CPI) as the measure for most pensions indexation following the Government s announcement in 2010 to move the statutory increase measure from RPI to CPI. The primary reason for the deficit increase was the fall in discount rate due to the fall in bond yields over this period, only partially offset by the rise in the value of bond assets held by the Schemes. The Scheme Actuary calculated that by extending the current Recovery Plan the deficit would be expected to be paid off by 2020 before allowing for the further deterioration since 31 March The Company agreed to pay deficit contributions of 7.3m p.a, increasing annually with RPI from 2015 until 2025, in recognition of the further deterioration after 31 March In 2010 the Company began an extensive review of strategic options to mitigate the risk of future increases in pensions costs. A wide range of options were evaluated. This resulted in a programme of activities carried out over including: Rationalising the governance of the Schemes, bringing the trustee boards together and tendering all adviser roles to ensure consistency across both Schemes and to achieve lower overall operating costs. This provided an efficient and effective platform for the Trustees to consider the Company s strategic proposals and objectives. After consulting with affected employees, closing the Schemes to the future accrual of benefits from 31 March These changes were designed so that the Company could achieve certainty over the cost of providing pension benefits for future service. In April 2013 the Schemes implemented a new option for members reaching retirement. The option allows members to exchange a portion of their pension which increases in payment for a higher, non-increasing pension. Where members accept this option it will reduce the exposure of the Schemes to future inflation and longevity risk. With the Company s support, the Schemes have also set up a joint Investment Sub-Committee with responsibility for setting the Schemes investment strategy. The Investment Sub-Committee has implemented a triggered de-risking strategy across both Schemes to lock in positive returns as they are achieved. The Company also considered other options but concluded that, at the present time at least, they would not improve the cost/risk profile of the Schemes, or were not appropriate. These will be kept under regular review, working with professional advisers. The funding position of the Schemes has worsened since 31 March At 31 March 2013 the deficit is estimated to be 85.6 million, primarily driven by further falls in the discount rate due to falls in bond yields. However, the Recovery Plan agreed at the 2011 valuations already reflected a deterioration in the deficits since 31 March It is therefore estimated that the existing Recovery Plan remains sufficient to remove the deficit by Auto-enrolment from 1 October 2013 will result in the Company having to contribute towards pension saving for a greater number of employees. When the Company decided on the pension changes in 2012 it was mindful of the increased cost of auto-enrolment and designed pension arrangements across all employees which would absorb these costs. However, taking into account the employee relations impact and the need to obtain Trustee agreement to closure the Company agreed to enhance affected members DC contributions until As a result costs will be marginally higher between 2015 and 2020, and are then expected to reduce from 2020 onwards. 3

5 Background and introduction to the pension schemes The Company sponsors two defined benefit pension schemes: The South East Water Pension Scheme The Mid Kent Group Pension Scheme It also operates two defined contribution pension schemes. The 31 March 2008 Scheme Funding valuations for the Schemes showed a combined deficit of 52.4 million, which the Company agreed to fund with Recovery Plan payments of 7.3 million p.a. to 2015 followed by 3.45 million p.a. from 2015 to Introduction The Company sponsors the following pension arrangements: The South East Water Pension Scheme ( SEWPS ), a defined benefit pension scheme The Mid Kent Group Pension Scheme ( MKGPS ), also a defined benefit pension scheme Collectively, the SEWPS and MKGPS are referred to as the Schemes. The Company has previously recognised the cost and risk exposure that could result from providing defined benefit pensions to employees, closing the SEWPS in 2002 and MKGPS in 2005 to new entrants. Employees could then join the Group Stakeholder Pension Plan ( the GSPP ) and the South East Water CPP ( the SEWCPP ), which are defined contribution pension schemes. Summary of Scheme Membership Summary of Membership GSPP & SEW Non SEWPS MKGPS DC Scheme Members Active Members Deferred Members Pensioner Members Total Source: Actives information provided by John Murphy on 2 nd July 2013 Deferred and Pensioner numbers at 31 March 2013 provided by the Scheme Actuary, Hymans Robertson 31 March 2008 Scheme Funding valuation results During 2009 the Company agreed the results of the Schemes 2008 Scheme Funding valuations with the Trustees. This fixed the contributions payable by the Company to the Schemes until the next triennial funding review. A summary of the valuation outcome is below: Summary of 31 March 2008 valuation results m SEWPS MKGPS Total Liabilities Assets Deficit Funding level 71% 89% 78% Employer future service cost (% of salary) 29% 27% Recovery Plan payments Source: 31 March 2008 valuation reports 5.95m p.a. 1.35m p.a. to 2015, to 2015, then then 0.6m 2.85m p.a. p.a. to 2025 to m p.a. to 2015 then 3.45m to

6 Introduction The 2011 Scheme Funding valuations The Schemes 31 March 2011 Scheme Funding valuations were agreed in 2012 and represent the most recent formal actuarial valuation of the Schemes available. This section: Summarises the results of the 2011 valuations Benchmarks the key assumptions adopted in the valuations Identifies the elements which contributed to the change in deficit levels from 31 March 2008 to 31 March 2011 Benchmarking analysis We have benchmarked the assumptions used for the 31 March 2011 Scheme Funding valuations against those used by other companies based on the latest information from The Pension Regulator s most recent survey of valuation assumptions. The survey covers around 1,900 pension scheme valuations with effective dates from 22 September 2010 to 21 September Of which, around 950 of the schemes had an effective date in either March or April 2011, similar to the valuations of the Schemes. We have also set out on the following pages a comparison between the key assumptions used for the Schemes and those used by six other water companies for their latest funding valuations. The valuation dates for these schemes ranged from 31 March 2010 to 31 March 2011.

7 The 2011 Scheme Funding valuations summary There was a combined deficit of 60.4 million across the Schemes at the 31 March 2011 valuations. Recovery Plan payments of 7.3m p.a. were agreed until Scheme Funding valuations deficit The Schemes carried out their most recent triennial funding valuations at 31 March 2011, the results of these are summarised below: Summary of 31 March 2011 valuation results m SEWPS MKGPS Total Liabilities Assets Deficit Funding level 69% 89% 76% Employer future service cost (% of salary) 33.8% 36.1% Recovery Plan payments p.a. to (increasing with RPI from 2015) The results of the valuations showed there was a deterioration in the funding position between the 2008 and 2011 valuations despite significant additional contributions paid by the Company. The key factors which influenced the deficit amounts are set out on pages 7, 10, 11 and valuation assumptions The 2011 valuations assumptions were derived using consistent principles to those negotiated with the Trustees for the 2008 valuations, albeit the Scheme Actuary advised updating the methodology used for life expectancies to reflect the latest research. The key assumptions are summarised below: Summary of key valuation assumptions SEWPS MKGPS Valuation method Gilt curve Gilt curve Margins over gilt curve Pre-retirement discount rate +1.5% +1.5% Post-retirement discount rate +0.6% +0.5% Life Expectancies (both schemes - from age 65) Males Females Current pensioner (aged 65) Future pensioner (aged 40) Source: 31 March 2011 valuation reports produced by Hymans Robertson 2011 valuations Recovery Plan In order to recover the deficit identified in the Schemes as at 31 March 2011, the Company and the Trustees to the Schemes agreed to a schedule of deficit recovery payments (the Recovery Plan) to remove the deficit as quickly as the Company could reasonable afford. Recovery Plan payments totalling 7.3m p.a. were agreed across the Schemes. These will increase in line with RPI from 1 April 2015 until 31 March Whilst the Scheme Actuary estimated that the Recovery Plan would eliminate the shortfall by 31 August 2020 the Company agreed with the Trustees that the Recovery Plan should reflect deficit contributions being paid until 31 March 2025 in partial recognition of the deterioration in the funding level between 31 March 2011 and the date the valuations were completed and a new schedule put in place. Agreed Recovery Plans m Year (beginning 1 April) SEWPS MKGPS Source: 31 March 2011 valuation reports based on assumed future (RPI) inflation of 3.56% p.a. 6

8 The 2011 Scheme Funding valuations progression of the deficit Progression of SEWPS deficit There was a deterioration in 70 the funding position between the 2008 and 2011 valuations despite nearly 14 million of additional m (11.7) (0.9) (12.8) 1.4 contributions being paid in by the Company This was primarily due to falls in bond yields resulting in a fall in the discount rate increasing liabilities, as well as underperformance of the scheme s assets resulting in a c 28 million increase in the combined deficit. This was partly offset by a change in the Schemes to using CPI instead of RPI for certain benefit revaluations. This is explained further on page 12. m 10 0 Progression of MKGPS deficit Deficit at 31 March Interest on deficit Deficit contributions 1.6 (1.9) Investment performance (1.7) Change in financial assumptions 5.3 Experience RPI to CPI Changes to longevity assumption Changes in bond yields affect both the assumptions and the performance of bond assets. These two categories should therefore be considered together to see the overall impact of market conditions on the Schemes. Further commentary is provided on page 10. (1.4) (1.0) 1.0 Deficit at 31 March Deficit at 31 March 2008 Interest on deficit Deficit contributions Investment performance Source: Hymans Robertson 31 March 2011 valuation reports Change in financial assumptions Experience RPI to CPI Changes to longevity assumption Deficit at 31 March

9 The 2011 Scheme Funding valuations benchmarking the discount rate The discount rates adopted by the Schemes are broadly in line with the Pensions Regulator s survey of around 1,900 pension schemes with a similar valuation effective date. When compared to six other water companies pension scheme valuations, the Schemes discount rates are less prudent than those used by four of the companies which used a dual discount rate approach but are no more prudent than any scheme on a single equivalent basis. (%) The Pensions Regulator The Schemes adopted a dual-discount rate approach, typically based on assuming a different margin above gilt yields is used to set the discount rate before and after retirement (the pre and post retirement discount rates ). Whilst this is a common approach to adopt in valuations, for benchmarking purposes the Pensions Regulator looks at a single equivalent discount rate for each scheme above long dated gilt yields at the relevant valuation date. For the Schemes, the single equivalent discount rates as at 31 March 2011 were: SEWPS: 20 year gilt yield plus 1.17% p.a. MKGPS: 20 year gilt yield plus 1.07% p.a. The chart below compares the Schemes single equivalent discount rates with that from the Pensions Regulator s survey. (An explanation of the chart is in the bottom right hand corner of this page.) The chart shows that MKGPS is in line with the median and SEWPS is slightly less prudent than median. Less prudence in an assumption means a lower liability is calculated which reduces the assessment of the liabilities in the pension scheme (asset values are taken at market value and are unaffected by the choice of assumptions). Single equivalent discount rates over 20 year fixed interest gilt yield SEW MKG 0.0 Source: The Pensions Regulator s 2013 Scheme Funding Survey Sector analysis Of the six other water companies compared, the Schemes were towards the less prudent end of the range of discount rates. Companies A, B, E and F used a dual discount rate approach with no margin over gilts post retirement. Therefore both pre and post retirement discount rates were more prudent than those used in the Schemes. However, this could reflect the differences in the underlying investment strategy between these schemes and the Schemes. Companies C and D use a single discount rate which is broadly in line with the rates used by the Schemes. Pre/post retirement discount rates over 20 year fixed interest gilts 2.0% Pre retirement premium Post retirement premium 1.5% Single equivalent rate More prudent Premium over 20 year gilts 1.0% 0.5% 0.0% SEWPS MKGPS A B C D E F Source: 31 March 2011 valuation reports and KPMG analysis Explanation of the Pensions Regulator s discount rate chart 5% above this line 50% of all valuations 5% below this line 75 th percentile median 25 th percentile 8

10 The 2011 Scheme Funding valuations benchmarking life expectancy The Schemes mortality assumptions reflect the Schemes demographic profile and the higher life expectancy projected in the south east of England compared to the national average. As expected therefore, when compared against the Pensions Regulator s survey and the sector analysis, they are more prudent than the median. The Pensions Regulator The Pensions Regulator s survey shows that the Schemes adopt mortality assumptions, which set life expectancy, that are more prudent than the median adopted by other schemes. In fact, the assumptions for the Schemes are in the upper 25 th percentile of life expectancies in the survey. Adopting life expectancy assumptions that are in line with the median from the Regulator s survey would reduce the liabilities in the Schemes by up to 5%, equivalent to years in average life expectancy. This divergence from the mean in part reflects the demographic profile of the Schemes membership compared to that of the average UK pension scheme. Evidence from the Office of National Statistics suggests that life expectancy in the south east of England is around one year higher than the national average. (years) Life expectancies for current male pensioners aged Both schemes More prudent Source: The Pensions Regulator s 2013 Scheme Funding Survey (years) Life expectancies for future male pensioners from age Source: The Pensions Regulator s 2013 Scheme Funding Survey Sector analysis The prudence in the Schemes mortality assumptions is evidenced again in the sector analysis but will again reflect the demographic profile of the Schemes membership compared to the others. Life expectancies male pensioners aged 65 Total life expectancy from age 65 (years) Future pensioner Current pensioner 86 SEWPS MKGPS A B C D E F Source: 31 March 2011 valuation reports and KPMG analysis 9

11 The 2011 Scheme Funding valuations financial market trends Between April 2008 and April 2011 gilt yields fell. This resulted in increases of around 10% to funding liabilities for most pension schemes. During this period, equity markets saw returns of around 15%, but because only a proportion of pension scheme assets are held in equities, most schemes experienced an increase in their deficits during this period. Annual spot rate Gilt Yields Since 31 March 2008 we have seen large falls in the level of gilt yields at durations under 20 years. As gilt yields are commonly used to set discount rates, the falls have caused increases in liabilities for most pension schemes. Whilst these changes have also led to an increase in the value of gilt assets held by pension schemes, in general the returns on gilt holdings have been insufficient to prevent deficits from increasing. Gilt Spot rates 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Duration (years) Source: KPMG analysis of Bank of England data March 2011 gilt curve March 2008 gilt curve The chart above illustrates a c.70 basis points reduction in gilt yields on average between March 2008 and March This typically increased pension scheme liabilities by around 10%. For the Schemes, 10% of the liabilities was 25 million at March Equity returns Since 2009 equity markets have produced significant returns, recovering from the low points reached after the market crashes during However, due to the large falls experienced in equity values from 1 April 2008 to 1 April 2009, the overall returns on equities over the valuation period has been around 15%. FTSE all share - total return April April April April 2011 Source: KPMG analysis Impact on the Schemes Market indicators can however only provide a guide as to the expected movement in asset values over time. In reality, actual scheme asset portfolios can move differently to market indices. Whilst MKGPS outperformed expectations by 1.7 million between the 2008 and 2011 valuations, SEWPS underperformed by 8.3 million. We do not hold detailed information on the Schemes asset performances between 31 March 2008 and 31 March 2011 to identify in more detail the reasons for these returns. 10

12 The 2011 Scheme Funding valuations demographic trends Since 2008 there have been significant developments in the assumptions used to set pension scheme members life expectancy, with the introduction of the SAPS tables and CMI projections. KPMG s accounting survey indicates that these have resulted in around a one year increase in life expectancies which is equivalent to increasing the liability in the Schemes by around 3%. Life expectancy The Actuarial Profession s Continuous Mortality Investigation ( the CMI ) carries out research into mortality and morbidity experience. This is used to develop mortality tables and projection models that are used to value the liabilities of the majority of pension schemes. Since 2008 there have been developments in the analysis of pension scheme members life expectancy which has led to widespread changes to the approach taken by pension schemes to estimate mortality rates. In October 2008, the CMI published the SAPS mortality tables, the first mortality tables to be based on UK pension scheme data. This was followed in 2009 by the release of the CMI Mortality projections which are based on the assumption that current rates of mortality improvement converge over time to a single long-term rate. This replaced the old cohort tables and is considered a more appropriate approach. The adoption of these updated tables and mortality projection models have increased the life expectancy assumptions for pension scheme members which has correspondingly increased funding liabilities (and deficits). Each year, KPMG analyses pensions assumptions used by companies in their 31 December year end accounting disclosures. The analysis covers over 300 companies. Summarised opposite is the increase in median life expectancy experienced in the survey since This illustrates the impact the adoption of new mortality tables and projection models have had on life expectancy assumptions. The increase in average life expectancies over the period is equivalent to adding 3% to the liabilities of the Schemes. Summary of average assumed life expectancy (male) Current Pensioner Future Pensioner Source: KPMG Accounting survey 2008 and 2011 Notes: Based on survey across over 300 companies. Life expectancies from age 65, future pensioner assumed to be currently aged 45 11

13 The 2011 Scheme Funding valuations RPI to CPI revaluation The combined deficit in the Schemes reduced by nearly 14 million following the Government s announcement in 2010 to use the CPI index for statutory pensions revaluation. Changes to the Schemes indexation from RPI to CPI During 2010 the Government announced that it would change the measure of inflation it used to determine future statutory minimum increases to pensions by reference to the Consumer Prices Index ( CPI ). Previously, the Retail Prices Index ( RPI ) had been used. The impact of this on UK occupational pension schemes depended on each schemes Trust Deed and Rules. In particular, the wording prescribing i) deferred revaluation for members who leave the scheme before retirement and ii) post retirement pension increases. As the rules permitted the change to CPI indexation the following changes were made: In the SEWPS the change to CPI applied to both deferred revaluation and all non-gmp pension increases in payment. This resulted in a decrease in the deficit of 12.8 million at the 31 March 2011 valuation. In the MKGPS the change applied to deferred revaluation and pension increases in payment relating to post 88 GMP only. This resulted in a decrease in the scheme s deficit of 1.0 million at the 31 March 2011 valuation. 12

14 Introduction Changes to the Schemes since the 2011 valuations In 2010 the Company began an extensive review of strategic options to mitigate the risk of future increases in pensions costs. A wide range of options were evaluated. This resulted in a programme of activities carried out over including rationalising the governance of the Schemes, bringing the trustee boards together and tendering all advisers to ensure consistency across both Schemes and to lower overall operating costs. The main actions identified as a result of this review were implemented after the 2011 Scheme Funding valuations were finalised. This section sets out commentary on the following developments relating to the Schemes since 31 March 2011: Announced closure of the Schemes to the future accrual of benefits from 2015 and replacement with Defined Contribution benefits Introduction of a member option on pension increases that can reduce pensions cost and risk exposure Introduction and implementation of de-risking triggers for the Schemes

15 Changes to the Schemes since the 2011 valuations closure to future accrual of benefits During 2011 the Company conducted an extensive review of its pension provision for employees. It concluded, after consulting with affected employees, that it would close the Schemes to future accrual of benefits from 31 March Background Commencing in 2010 the Company reviewed the risks relating to the Schemes and assessed how these could be mitigated. The Company concluded that it was inappropriate to continue to build up further risky liabilities in the Schemes through future accrual whilst it looked at reducing risk in other areas of the business. The Company therefore carried out further analysis of pension provision to employees during It ultimately approached the Trustees of the Schemes to discuss closing the Schemes to the future accrual of benefits with effect from 31 March Recognising the risks attached to benefits built up until closure in 2015, the Company also proposed to limit Pensionable Salary increases until closure to cap the rate at which additional benefits can accrue up to 31 March Negotiations and consultation The Company conducted extensive negotiations with the Trustees as well as a 60 day formal consultation with employees to help their understanding of the proposals and to hear their views. In particular, the employee consultation included: An initial announcement letter, containing a Q&A booklet and illustrative member examples Group seminars to explain the changes in person One to one meetings with any employee who requested additional support An online modelling tool to help assess the impact of the changes A helpline to answer technical questions Taking into account the employee relations impact and the need to obtain Trustee agreement to closure the Company agreed to enhance affected members DC contributions from 31 March 2015 to 31 March Conclusions and final agreed changes In December 2012 the Company announced its conclusions following employee consultation, setting out the changes it would be implementing to the Schemes for employees currently accruing benefits in them. A summary of the final changes are as follows: Capping of pensionable salary increase at 3% for the 1 April 2014 pay review (the 2013 pay negotiation had already agreed a figure of 3%) Closure to the future accrual of benefits in the Schemes from 31 March 2015 Enhanced employer DC contributions for former DB members up until March 2020 of: 17% between April 2015 and March 2017 (2 years) 16% between April 2017 and March 2019 (2 years) 15% between April 2019 and March 2020 (1 year) An increase to maximum employer contributions in the DC Scheme from 8% to 10% for all DC members These changes provide increased certainty over the cost of providing pension benefits in future. They also allow the Company to broadly maintain pensions costs at their current level in the medium term. This is despite the expected increase in pension contributions resulting from auto-enrolment (see page 20). 14

16 Changes to the Schemes since the 2011 valuations pension increases In April 2013 the Schemes implemented a new option for members when reaching retirement. The option allows members to exchange a portion of their pension which increases in payment for a higher, nonincreasing pension. This option will reduce the exposure of the Schemes to future inflation and longevity risk. Pension Increase Exchange Option As part of the Company s review of the risks in the Schemes it identified an opportunity to reduce the inflation exposure and life expectancy exposure. The opportunity provides members approaching retirement with the option to exchange the non-statutory part of their pension built up before 1997 which increases each year in payment with inflation - for a higher, non increasing pension. The Company presented the proposal to the Trustees of the Schemes and assisted in designing the factors to adopt. The Pension Increase Exchange Option has now been implemented and is available to all members of the Schemes at retirement. Based on experience of similar exercises, take-up of this option in expected to be in the range of 25% to 50% of members. As members elect this option it will reduce the risk exposure of the Schemes for two reasons: As the converted pension does not increase with inflation this reduces the level of inflation exposure in the liabilities As the converted pension is larger at the outset but does not increase, more pension is paid in the shorter-term relative to the longer-term. This therefore reduces the Schemes exposure to longevity risk (i.e. increasing life expectancy) A number of other companies have implemented similar options, including BT, ITV and Axa. 15

17 Changes to the Schemes since the 2011 valuations de-risking the Schemes assets The Trustees of the Schemes have set up a joint investment sub-committee to work more closely together and rationalise advisers across both Schemes. In addition, the Schemes now employ a triggered derisking strategy to capitalise on positive funding experience. Introduction As part of the Company s review of its pension provision it also reviewed the governance arrangements of the Schemes and their respective investment strategies. The main outcomes of this review were: The Trustees of the two Schemes have set up a joint investment sub-committee to work more closely together and therefore reduce operating costs Rationalising of the advisers to the Schemes Agreeing a de-risking strategy for the assets of the Schemes Governance and advisers The Company supported the Trustees of the Schemes to explore ways to work more closely together and to consider whether a single set of advisers across both Schemes would improve the efficiency of the Schemes governance. The Trustees of the Schemes agreed to set up a joint sub-committee to tender the advisers to the Schemes. Following a comprehensive tendering exercise a single adviser was appointed, Hymans Robertson, as administrator, Scheme Actuary, actuarial adviser and investment adviser, across both Schemes. This is expected to reduce the long term running costs as well as providing an efficient and effective platform for the Trustees to consider the Company s strategic proposals and objectives. Investment Sub-Committee The Trustees also set up a joint investment sub-committee (ISC) including greater representation from the Company. The ISC delivers two objectives. Firstly, it aims to provide more consistency in the investment strategy adopted by both the SEWPS and MKGPS. This helps the Company when managing its risk exposure, as well as improving knowledge sharing across the Schemes. Secondly, it allows the Schemes to employ a greater level of sophistication when selecting the assets to form the growth and matching portfolios in the investment strategies. This is expected to deliver a more efficient strategy in terms of improving returns and/or reducing risk. Triggered de-risking strategy The Schemes invest in a mix of growth assets and matching assets, similar to other UK Defined Benefit schemes. Growth assets are selected in order to reduce the expected cost of providing the pensions promised but expose the Schemes, and therefore the Company, to volatility and risk of future cost increases. Following a review conducted by the ISC with its investment adviser both Schemes now follow a triggered de-risking strategy. The strategy aims to move the Schemes assets from growth portfolios to liability matching portfolios over time to lock in any outperformance as it is achieved. The long term aim of the strategy is to reduce the growth asset allocation in both Schemes to around 30%. The funding level of the Schemes is monitored monthly. The ISC aims to review and then implement changes as quickly as possible once it is identified that a trigger point has been reached. The first trigger point for the MKGPS has already been reached and as a result the MKGPS s allocation to growth assets has already reduced from 50% to around 45%. 16

18 Introduction This section sets out commentary on factors which could influence the future cost of pension provision for the Company: Projected pension costs over AMP6 and AMP7 Projected future deficit contributions Projected cost of future pension accrual Anticipated external changes

19 Projected future deficit contributions The funding position of the Schemes has worsened since 31 March At 31 March 2013 the deficit is estimated to be 86.5 million. We estimate that the extended Recovery Plan agreed as part of the 2011 valuations continues to be broadly sufficient to meet the deficit. However, any further deterioration in market conditions, or adverse changes in the actuarial assumptions, would be expected to increase the cash commitment required by the Company. Annual spot rate Estimated funding position of the Schemes as at 31 March 2013 The most recent formal Scheme Funding valuation for the Schemes was carried out as at 31 March However, each year the Scheme Actuary must calculate an estimate of the updated funding position of the Schemes based on latest market conditions. The most recent funding updates for the Schemes was carried out as at 31 March The results, summarised below, show that the funding position has worsened since 31 March 2011 primarily due a reduction in the discount rate due to further falls in gilt yields. Updated funding position for the Schemes from 31 March 2011 to March 31 March Change over m period Liabilities Assets Deficit Funding level 76% 72% - 4% Source: Hymans Robertson March 2013 funding updates Changes in gilt yields since 31 March 2013 The chart below illustrates a c.170 basis points reduction in gilt yields in the last two years. This typically increased pension liabilities by around 35%. 5.0% 4.0% 3.0% 2.0% March 2013 gilt curve 1.0% March 2011 gilt curve 0.0% Duration (years) Source: KPMG analysis of Bank of England data Possible impact on the Recovery Plan Assuming the current deficit of 85.6 million remains at the 31 March 2014 Scheme Funding valuations, we estimate that the existing Recovery Plan will still be broadly sufficient to remove the deficit by Specifically, payments of 7.3 million p.a. which increase each year with RPI up to 2025 would be required. The existing Recovery Plan can be maintained because of the agreement at the 2011 valuation to extend the Recovery Plan to 2025 in partial recognition of the deterioration in the funding level between 31 March 2011 and the date the valuations were completed (see page 6). However, the position of the Schemes remains volatile and subject to future reviews with the Trustees on the actual assumptions. Therefore any further deterioration in the funding position, however small, could result in a commitment for additional deficit contributions being needed in the Recovery Plans coming out of the 2014 valuations. Sensitivity of Recovery Plan To illustrate the volatility of the Company s Recovery Plan at the 2014 Scheme Funding valuations, the table below summarises the impact on the Schemes deficit and Recovery Plan contributions from example changes in assumptions (assuming no change in asset levels). Impact at March 2014 Scheme Funding valuations m Change in deficit Change in Recovery Plan 50 basis point decrease in discount rate + 16m + 1.5m p.a. 50 basis point increase in future inflation + 16m + 1.5m p.a. Source: Hymans Robertson funding updates and KPMG analysis The Scheme Funding deficits may improve ahead of the 31 March 2014 valuations. However the Pensions Regulator expects company contributions at each valuation to remain the same or increase, unless there are serious concerns about a sponsor s financial position. Therefore contributions will not change from 7.3 million p.a., rather the Company will likely reduce the length of the Recovery Plan. Source: KPMG analysis of Bank of England data 18

20 Projected cost of future pension accrual Auto-enrolment from 1 October 2013 will result in a greater proportion of employees earning pension benefits. This will increase the cost of future pension provision to the Company. Auto-enrolment Due to Government legislation, from 1 October 2013 the Company will be expected to auto-enrol all eligible employees who do not currently participate in a Company pension scheme or in the group s DC scheme, the GSPP. This subgroup of the Company s employees is very significant at 441 employees, representing 9.2 million p.a. or 43% of the Company s total payroll. Projected cost of future pension accrual On the following page we have set out projections of the cost of providing pension benefits to the Company s employees over the next 15 years. The projections allow for: Current employees accruing benefits in the Schemes The anticipated expenses of running the Schemes Current employees accruing benefits in the GSPP Employees eligible for auto-enrolment from 1 October 2013 Allowance is made in the modelling for the announced closure of the Schemes to future accrual from 31 March 2015 and the 2% p.a. increase in the DC rate for the GSPP. The model recognises that not all employees will decide to remain in the DC scheme following auto-enrolment and therefore assumes 10% will opt out. This opt out rate is broadly comparable with the rates experienced by other companies who have already auto-enrolled, although the actual opt out rate is impossible to predict with certainty. The model also makes an allowance for employees retiring or leaving the Company. In such situations the model assumes employees are replaced by new staff at the same salary levels. The payroll profile is therefore assumed to be stable in the future. All costs quoted are in real terms, and payroll is estimated to increase each year with inflation. 19

21 Projected cost of future pension accrual (continued) The cost of providing pension benefits will reduce from 2020 when the enhanced DC contributions for former DB members end. Contributions between 2015 and 2020 would have been broadly the same if the Schemes had not closed to the future accrual of benefits, but the contribution amounts for providing DC benefits are much more predictable. m Projected cost of future pension accrual / / / / / / / / / / / / / / /28 Year (April to March) Current DB members DC cost for DB members DB expenses Current DC members Cost of auto enrolment (for current non members) The impact of closing the Schemes to future accrual We have also projected the cost of future pension accrual for the Company had it continued to allow accrual of benefits in the Schemes after We estimate that without closure, the costs would have been around 10% higher after 2020 than the total costs above. Contributions until 2020 are expected to increase slightly from the current figure of c 2.9m p.a. due to auto-enrolment and the enhanced contribution rates for former DB members over the period from 2015 to Had the Company sought greater certainty of pension contributions through a low risk investment strategy instead of closure, annual contributions to the Schemes would have been considerably higher. Both in terms of the estimated cost of future pension accrual and because a higher deficit would likely be recognised, requiring additional Recovery Plan contributions from the Company. 20

22 Anticipated external changes In May 2013 the 2013 Pensions Bill set out a new objective for the Regulator, who also released a statement regarding Scheme Funding. The statement reminds trustees of the flexibility within the Scheme Funding Legislation, whilst the new objective requires the Regulator to minimise any adverse impact on the sustainable growth of an employer. However, they are not expected to result in the Company being able to reduce contributions in the short to medium term. Introduction of Solvency II type regulation for European pension schemes poses no immediate threats to the Company s cash commitments but continues to be an unknown risk that could result in higher Company funding requirements in future. Regulator statement and new statutory objective The May 2013 Pensions Bill included a new statutory objective for the Pensions Regulator. Under the objective the Regulator will be required to minimise any adverse impact on the sustainable growth of an employer in relation to funding valuations. In addition to this the Pensions Regulator also released a statement in May 2013 about Scheme Funding valuations in light of the current low gilt yield environment. The key points in the statement were: The Regulator highlights flexibility in setting valuation discount rates as well as recovery plans. In particular it draws attention to the ability to set discount rates based on a scheme s investment strategy and without reference to gilt yields. It also notes that return expectations can vary over time, and gives examples of the addition of 0.25% to discount rates compared to 2010 Recognition that it may be appropriate to prioritise investment in the business over pension contributions where this improves the employer covenant Their previous trigger points such as 10 year recovery plans have been replaced with a more sophisticated set of risk metrics which they will used to decide when to intervene in valuations The Regulator is continuing to stress the need for schemes to take an integrated approach to looking a covenant, investment and funding The new objective and the Regulator s recent statement will be welcomed by pension scheme sponsors in the UK. However, prudent funding is still a requirement under the legislation and the Pensions Regulator guidance suggests deficit contributions should continue to be based on reasonable affordability. Therefore these announcements not expected to result in the Company being able to reduce contributions in the short to medium term. Solvency II for pension schemes For some years, the European Commission has been developing a new regime for the prudential regulation of insurance companies, known as Solvency II. Alongside this, the Commission has been discussing whether the present pensions directive the Institution for Occupational Retirement Provision (IORP) directive should be strengthened, and indeed whether some or all of the full Solvency II regime for insurers should apply to pension schemes. In January 2013 the European Insurance and Occupational Pensions Authority (EIOPA), in conjunction with national pensions regulators, completed a Quantitative Impact Study (QIS) on their initial proposals for a Solvency II funding regime for pension schemes. EIOPA reported that the adoption of Solvency II for pension schemes would result in an increase in UK pension scheme deficits of around 150 billion. One of the reasons for this is the greater weighting of risk assets in the UK s pension scheme portfolios, leading to higher solvency capital requirements. In May 2013 the Commission announced that they recognise the need for much more work to be done before a workable proposal, acceptable across Europe, can be produced for Solvency II for pension schemes. Therefore, Solvency II poses no immediate threats to the Company s cash commitments to the Schemes. However, it continues to be an unknown risk that could require an increase in cash funding requirement in the future. 21

23 Summary of pensions de-risking strategies past and future This table summarises the potential actions available to the Company to de-risk the Schemes. Actions have been split into those already implemented, those analysed but deemed not appropriate in the medium term, and those to be kept under review. Introduction The Company has carried out extensive work since 2009 to reduce the risks run in the Schemes. A summary of the actions taken is set out in the left hand column of the table below. The Company s initial review considered all options available at the time to mitigate cost and risk of future cost increase, and the Company keeps under review new options which arise. Examples of potential measures to mitigate cost and risk Already implemented Considered unlikely to be appropriate in medium term The review showed that some options were inappropriate for the Company in the short to medium term, whilst others were identified as possible actions that could be kept under review, and potentially implemented if certain criteria were met. The Company continues to periodically review these options, which are also summarised in the table below. Considered and kept under review Increase the joint working by the Trustee groups Tender and appoint joint advisers across the Schemes Set-up an Investment Sub-Committee to manage the assets of both Schemes Implement a triggered de-risking strategy Close the Schemes to the future accrual of benefits from 2015 Limit pensionable salary increases prior to closure Implement a Pension Increase Exchange option at retirement for members Enhanced Transfer Value exercise (Current market conditions suggest insufficient benefits versus cost of implementation as well as risks of implementation) Full buy-out (Current cost means buy-out not appropriate) Full merger of the Schemes / Joint investment fund (High costs for minimal additional benefit at the current time) Pension Increase Exchange option for existing pensioners (Take up of option at retirement to be monitored before costs incurred of running option for existing pensioners) Pensioner buy-in (Current market conditions deemed unsuitable, but periodically reviewed) Asset Backed Funding (Kept under review, would be subject to identifying suitable assets, other restrictions and financial potential it could deliver) Flexible Retirement Option for non-pensioners close to retirement (Potential benefits limited currently, relatively new in the market, implementation to be reviewed periodically) 22

24 Appendices

25 Appendix 1 mortality assumptions Post retirement mortality assumptions (both schemes) Base tables Current pensioners Future pensioners 100% of S1PMA for males and 100% of S1PFA for females 100% of S1PMA for males and 100% of S1PFA for females Future improvements Starting rates Long term rates of improvements Convergence from starting to long term rates Calibrated to ONS data based on latest available data as provided by the CMI in their 2011 Mortality Projections Model 1½% p.a. for men; 1% p.a. for women Improvements in longevity assumed to have not yet peaked. Convergence to long term rates of improvement consequently takes longer than CMI default. Technically the proportion of convergence remaining at mid point is 75% for both period and cohort effects Period of convergence: 10 years at age 45 and below increasing linearly to 40 years at age 75 and above for period effects; 5 years for 1913 birth generation and earlier, increasing linearly to 40 years for 1948 birth generation onwards 24

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