The Chancellor s surprise pension announcements mean all employers must act now.

LCP CORPORATE PENSIONS UPDATE APRIL 2014 Including special Budget comment The Chancellor s surprise pension announcements mean all employers must act now. IN THIS ISSUE A special extended edition of the LCP Corporate Pensions Update. p2 needed from all employers p3 The Chancellor s Budget on 19 March 2014 is likely to mark (including cash balance schemes) p4 The Budget: what are the next steps for DB scheme sponsors? p8 from the Budget, and give our recommendations on what Using a different measure of inflation could wipe out pension deficits p9 More European red tape to be imposed on UK pension schemes the beginning of a total change in mindset on pension matters. We summarise some of the key points arising The Budget: what are the next steps for DC scheme sponsors? In this special extended edition of the LCP Corporate Pensions Update we consider the following issues: The Chancellor s revolutionary Budget for pensions action Key UK pension assumptions and statistics* 31 Mar all employers should be considering now; 31 Dec 31 Mar 2014 2013 2013 IAS19 discount rate 4.1 4.6% 4.2-4.7% 4.0-4.7% opportunities to materially reduce pension scheme Assumed RPI 3.3-3.6% 3.3-3.6% 3.3-3.6% liabilities; inflation 2.0-2.9% 2.0-2.9% 2.0-2.8% 3.5% 3.6% 3.0% 6,598.4 6,749.1 6,411.7 Alongside this, we look at whether changes in National Statistic definitions for inflation measures could bring Finally, we comment on the main factors behind the Assumed CPI inflation European IORP II proposals, and what they could mean Long term gilt for UK pension scheme sponsors in the relatively near yield future. FTSE 100 index * the figures shown are indicative ranges, different figures may be appropriate depending upon the individual circumstances

2 The Chancellor s revolutionary Budget for pensions action needed from all employers. On 19 March 2014 the Chancellor delivered his budget. The implications of this budget are likely to be dramatic and far reaching for pensions, impacting both defined contribution (DC) schemes and defined benefit (DB) schemes. Below, and in the following pages, we summarise the new proposals (which are subject to consultation), and suggest some immediate actions for corporate pension scheme sponsors. The headline proposals An intention to introduce full flexibility for the way in which DC scheme members can take their pension benefits from April 2015 (including the option to take the entire DC pot as a cash lump sum on retirement) A requirement to offer paid for guidance to all retiring DC members on the options available to them Some immediate short-term relaxations in the rules that currently restrict how pension scheme members can take their benefits Critically, an open question on whether transfers from DB schemes to DC schemes should be permitted in future Action All employers need to consider how the various different consultation outcomes could impact on their businesses. We encourage employers to respond to the consultation with their views. The consultation period closes on 11 June 2014. Budget 2014: Opportunities and recommended next steps for DB scheme sponsors. LCP Webinar 9 April 2014 11:00am The headlines accompanying the Chancellor s Budget announcements on pensions relate primarily to DC schemes. However, the knock-on implications for DB sponsors could be extremely significant, and there may be a number of new opportunities for de-risking within a relatively short time-frame. To register visit: www.lcp.uk.com/news--publications/ events/2014/2014-04-09-budget-2014-dbschemes-webinar/

3 The Budget: what are the next steps for DC scheme sponsors? (including cash balance schemes) DC schemes The new flexibility in how DC funds can be utilised on retirement is likely to be welcomed by a number of pension savers. It is also likely to mean increased interest and engagement from members in relation to their expected retirement benefits. With or without the Budget announcements, DC scheme sponsors have a duty to regularly review the pension arrangements they provide so as to ensure they remain fit for purpose. In addition, The Pensions Regulator is placing ever-increasing emphasis and scrutiny on DC schemes. Under the government s proposals, the fundamental dynamics of how DC schemes can provide for income in retirement will change and hence DC reviews will be required in some form. At the very least, employers should take action now (or ensure the trustees/contract providers are taking action now, where appropriate) to: Review the default investment strategies in place for their schemes. If members begin opting to take more cash on their retirements in future, default investments designed to broadly track annuity pricing may no longer always be appropriate. Review the communication material provided to members. If there are going to be more options available to members, with increased flexibility, then members need to be aware of this now to ensure they are able to make decisions which best fit with their circumstances. Alert individuals who may be retiring over the coming months to the proposed changes. If there is increased flexibility from April 2015, some members may decide to defer drawing their benefits until the new regime is up and running. Consider whether the type of DC arrangement being provided to employees remains suitable. For example, the requirement to offer paid for guidance to members on their retirements may potentially make contract-based DC schemes relatively more attractive than at present.

4 The Budget: what are the next steps for DB scheme sponsors? DB schemes Whilst the headline budget announcements relate to DC schemes, the implications could be far more wide reaching, impacting on DB schemes as well as DC schemes. This could present numerous opportunities for corporate pension scheme sponsors. The consultation introduced during the Budget, and running for three months, is open in terms of whether or not the new flexibilities in DC schemes should also extend to private sector DB members. In particular, specific points made in the consultation document are that: from a philosophical perspective, the government would be keen to extend the new options to all DB members; but on the other hand, the government is concerned that this may have a significant impact on the amount of cash moving between different investment markets, and therefore on the Treasury s ability to raise money in the gilt market. Accordingly, the consultation offers a number of possible options from a complete ban on all future DB to DC transfers, to full flexibility to fully cash-out DB benefits. Whatever the eventual consultation outcome, uncertainty surrounding what will be permitted post-consultation means employers need to act now in order to consider opportunities which could potentially disappear (and also plan for those which might arise). Short-term actions Before we know the outcome of consultation At one extreme, a complete ban on future transfers from DB to DC in the coming months may present a one-off window for members to transfer out now in order to benefit from new DC rules when they retire. Accordingly this may result in an influx of DB transfer quotation requests, and potentially also give a very short window for employers to embark on specific projects to remove DB risks. The points below therefore all need careful consideration now. We should, however, highlight that there is always a risk that the government decides to ban DB transfers at any time, or decides not to allow any flexibilities to DB transfers from April 2015. Factor the Budget announcements into any strategic corporate pension decisions: The changes which could arise as a result of the consultation are vast. Employers should therefore take a step back to consider whether the announcements mean any strategic decisions or policies linked to pensions need re-considering. In addition, if any pension projects and/or review exercises are currently underway, their continuing attractiveness and viability should be investigated as a matter of urgency. Consider implementing liability management exercises: Increased DC flexibility could mean that enhanced transfer value (ETV) and total pension exchange (TPE) options immediately become more attractive to members. Additionally increased take-up rates for such exercises will increase the corresponding potential risk reduction achievable for employers. Such exercises are only permissible if DB to DC

5 The Budget: what are the next steps for DB scheme sponsors? (cont d) DB schemes transfers are allowed so if employers believe that such exercises might be attractive, but not available in future, they should consider acting now. Consider performing a de-risking feasibility analysis: Implementing liability management exercises may not always be realistically feasible in the short-term timeframe in question. Therefore, if employers believe that DB to DC transfers will continue to be available post-consultation, now is the time to perform (or update) a feasibility analysis. Performing the cost/benefit analysis and project planning now, and getting the required data in place ready to go to market will help to maximise the corresponding benefits. Being ready to proceed once the consultation outcome is known could also lead to some significant first-mover advantages if the markets become swamped with such exercises shortly after the consultation announcements. Consider the benefits of some immediate relaxations in rules: One immediate reform is the ability to adopt a larger degree of flexible drawdown of pension savings for members who have a certain level of guaranteed retirement income. The threshold for flexible drawdown being permitted for DB scheme members has reduced to a guaranteed pension income of at least 12,000 per annum (the previous threshold was 20,000 per annum). This includes state benefits. Any pension entitlement over and above this amount can therefore potentially now be cashed out in some form - reducing DB risk in the scheme for employers if members opt to do so. At the same time, the thresholds under which small pensions are eligible to be fully taken as trivial cash lump sums have increased. Both of these relaxations may present opportunities for employers to consider removing cost and risk from their pension schemes. Flexible drawdown threshold Previous threshold 20,000 pa Pension entitlements above a reduced threshold can now be cashed out, potentially reducing DB risk in your scheme New threshold 12,000 pa Ensure scheme transfer value assumptions are appropriate: Employers should be proactive with the scheme trustees to check whether the existing method and assumptions for calculating DB transfer values remains appropriate, or whether the Budget announcements may be a catalyst for suggesting changes. In practice the assumptions used to calculate transfer values can be key to the relative merits of certain liability de-risking exercises (see above), and if such exercises are likely to proceed then it is important to ensure a sensible starting point for the cash transfer amounts available to members.

6 The Budget: what are the next steps for DB scheme sponsors? (cont d) DB schemes Medium term actions Once the outcome of the consultation is known In the event that DB to DC transfers are banned (or any DB to DC transfers become specifically ringfenced), then there may be little direct fundamental change within the DB pension world - unless of course the short-term actions mentioned earlier have changed the make-up of your scheme, or the macroeconomic consequences of the DC changes significantly affect the DB investment markets. However, if the full DC flexibilities are extended to DB transfers, then it is a very different story. For example, if a typical DB scheme sees c.50% of eligible members transferring their DB entitlement to DC, on or shortly before, their retirements, the shape of the scheme will change significantly, as illustrated below. Existing typical DB cashflow shape 90 Active 80 Deferred 70 Pensioner m 60 50 40 30 20 10 0 2013 2029 2045 2061 2077 2093 Possible DB cashflow shape under new budget proposals 90 Active 80 Deferred 70 Pensioner 60 50 40 30 20 10 m 0 2013 2029 2045 2061 2077 2093 Significant changes in the cashflow profile of DB pension schemes will have numerous knock-on implications for employers, and the points below will require consideration: Consider benefit change options: DC and cash balance pension schemes may become more attractive to members, which could be a new catalyst for employers to close off any further traditional DB accrual. Review investment strategy: If a substantial proportion of your scheme membership will, under new rules, choose to cash-out their benefits and transfer into a DC scheme traditional longer-term investment strategies may no longer be appropriate. Employers should engage with trustees to consider whether a material number of transfers-out can be expected, and accordingly whether the scheme investment strategy needs a full review.

7 The Budget: what are the next steps for DB scheme sponsors? (cont d) DB schemes Consider implementing liability management exercises: The new DC flexibility could mean that enhanced transfer value and total pension exchange exercises may immediately become more attractive to members. Once certainty is known on what will be permitted in future, the potential benefits to employers from such exercises could be further increased, and without any of the corresponding risks (perceived or otherwise) associated with pushing such exercises through in the immediate short-term. Consider buy-in/buyout: Buy-in/buyout pricing may see a material improvement as insurers look to transact more bulk annuity business in the light of a removal of the requirement for retirees to buy annuities from DC pots (ie, a previously guaranteed source of business for insurers could be disappearing). Review pensions accounting assumptions: Is there now a realistic expectation that a material proportion of scheme members will opt to transfer out from DB into DC at the point of retirement (or before retirement)? If so, incorporating such an assumption is likely to mean healthier balance sheets and lower future P&L costs. Employers should therefore investigate the scope for doing so with their advisors/auditors. employers should look into whether the new Budget developments could be allowed for in a way which benefits the outcome for the employer. Where valuations are not ongoing or in the pipeline, employers should consider whether requesting a new valuation could result in modified funding plans that better meet their objectives and expectations. Longer term actions If a trend emerges whereby a significant number of DB scheme members choose to transfer to DC prior to, or at, their retirement this will typically result in a shorter duration of future benefit payments for traditional DB schemes. With all else equal we anticipate this will mean employers can realistically bring forward target dates for the ultimate endgame of transferring their remaining DB obligations to the insurance markets. As ever, we believe there will still be supply and demand constraints in achieving such objectives and so there should be first-mover advantages to employers from taking some of the steps recommended in this Corporate Pensions Update. Review funding plans: A material number of transfers-out from DB to DC could, as highlighted in the images above, result in a fundamental change in the benefit payment profile for your DB schemes. Where valuations are ongoing,

8 Using a different measure of inflation could wipe out pension deficits. Employers should check to see if pension increases in the schemes they sponsor should in future be linked to the new RPIJ index, which could reduce, or even eliminate, pension deficits. For some time, pension increases were linked to the Retail Prices Index (RPI), the original measure of UK inflation. Then in 2010, the government changed statutory minimum pension increases so as to be based upon a different index, the Consumer Prices Index (CPI). Relative to the RPI, use of CPI indexation generally results in lower pension increases. Depending on the details of each particular pension schemes rules, some employers found their pension increases were reduced overnight with the change to a CPI-link, hence reducing the value of their assessed pension liabilities, sometimes very substantially for example, BT saw a 3bn gain. Other employers found that the small print of their pension scheme rules meant that they had to carry on giving the higher pension increases required by the RPI measure. and decided that it should no longer be classified as a National Statistic. An alternative index, RPIJ, was devised which corrects the flaws in RPI, and RPIJ has been published as a national statistic since January 2014. If RPI is flawed, and the ONS have dropped it, is it suitable for pension increases? As it was back in 2010, the answer will again depend on the scheme rules to some extent, as shown by the following example: Possible future scenario The pension scheme rules say that pension increases should be provided in line with the published UK measure of retail prices inflation. Historically, RPI has been used. The employer asks for a legal opinion in light of the recent changes, which confirms that RPI is no longer appropriate, as it has been downgraded from the status of a national statistic and a new inflation measure has been given that status. 6.00% 5.00% RPI RPIJ The employer and trustees agree that going forwards, the lower RPIJ inflation measure is to be used. 4.00% 3.00% 2.00% The scheme s funding deficit was over 10% of the value of the liabilities, but it is entirely removed by the switch in inflation measures, removing the need for deficit reduction contributions. 1.00% 0.00% Jan 2010 Jan 2011 Jan 2012 Jan 2013 Jan 2014 The employer works with the trustees to carefully communicate the change to members to reassure them that their pensions earned to date will continue to increase, and that the increases remain inflation-linked. Now a similar scenario is being played out again. In 2013 the Office for National Statistics (ONS) performed a review, and concluded that the formula behind the RPI index was flawed. As such, they stated that it does not meet international standards Of course some employers will find their pension scheme rules require RPI increases to be maintained. Once again, employers and members face a small print lottery on pensions.

9 More European red tape to be imposed on UK pension schemes. On 27 March a proposal for a new European Directive on pensions was published. It is intended that this will lead to new legislation which will apply to UK pension schemes from 1 January 2017. The proposed legislation does not impact on the funding of UK pension schemes. Instead it introduces a raft of detailed governance and disclosure requirements, many of them lifted from the corresponding European legislation relating to insurance companies (known as Solvency II). Action When considering pension strategy bear in mind that the expenses of running pension arrangements are likely to increase materially from 2017. If there are opportunities to settle legacy pension liabilities before 2017, this therefore may be attractive. The directive will apply to both defined benefit and defined contribution arrangements. The new requirements are potentially onerous for example it is envisaged that each pension scheme will be required to have an internal audit function in place. Schemes will have to complete risk assessments, the detail of which will be set out in supplementary legislation. There is still a concern that these assessments may require completion and disclosure of complex and prudent holistic balance sheets, which were previously proposed as a basis for defined benefit scheme funding, but faced down by a coalition of countries including the UK.

Any questions? If you would like any assistance or further information on the issues raised, please contact Alex Waite, Alex Whitley or the partner who normally advises you at LCP via telephone on +44 (0)20 7439 2266 or by email to enquiries@lcp.uk.com. Other specific contacts: Budget 2014: Alex Whitley or Jonathan Camfield RPIJ: Alex Waite or Tim Marklew Alex Waite Partner alex.waite@lcp.uk.com +44 (0)1962 872738 Alex Whitley Partner alex.whitley@lcp.uk.com +44 (0)1962 872717 IORPII: Jonathan Camfield or James Atherton LCP events We hold a range of events that provide clear information and analysis on important pensions and investment topics. Bringing together LCP experts and industry speakers, our events include conferences, breakfast briefing seminars, webinars, topic lunches, round-table debates and various training sessions. For full details of all events and to register, please visit www.lcp.uk.com/events The LCP Corporate Pensions Update is based on our current understanding of the subject matter and relevant legislation which may change in the future. Such changes cannot be foreseen. This document is prepared as a general guide only and should not be taken as an authoritative statement of the subject matter. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this Corporate Pensions Update can be accepted by LCP. LCP is a firm of financial, actuarial and business consultants, specialising in the areas of pensions, investment, insurance and business analytics. Lane Clark & Peacock LLP London, UK Tel: +44 (0)20 7439 2266 enquiries@lcp.uk.com Lane Clark & Peacock LLP Winchester, UK Tel: +44 (0)1962 870060 enquiries@lcp.uk.com Lane Clark & Peacock Belgium CVBA Brussels, Belgium Tel: +32 (0)2 761 45 45 info@lcpbe.com Lane Clark & Peacock Ireland Limited Dublin, Ireland Tel: +353 (0)1 614 43 93 enquiries@lcpireland.com Lane Clark & Peacock Netherlands B.V. Utrecht, Netherlands Tel: +31 (0)30 256 76 30 info@lcpnl.com Lane Clark & Peacock UAE Abu Dhabi, UAE Tel: +971 (0)2 658 7671 info@lcpgcc.com All rights to this document are reserved to Lane Clark & Peacock LLP ( LCP ). This document may be reproduced in whole or in part, provided prominent acknowledgement of the source is given. We accept no liability to anyone to whom this document has been provided (with or without our consent). LCP is part of the Alexander Forbes Group, a leading independent provider of financial and risk services. Lane Clark & Peacock LLP is a limited liability partnership registered in England and Wales with registered number OC301436. LCP is a registered trademark in the UK (Regd. TM No 2315442) and in the EU (Regd. TM No 002935583). All partners are members of Lane Clark & Peacock LLP. A list of members names is available for inspection at 95 Wigmore Street, London W1U 1DQ, the firm s principal place of business and registered office. The firm is regulated by the Institute and Faculty of Actuaries in respect of a range of investment business activities. The firm is not authorised under the Financial Services and Markets Act 2000 but we are able in certain circumstances to offer a limited range of investment services to clients because we are licensed by the Institute and Faculty of Actuaries. We can provide these investment services if they are an incidental part of the professional services we have been engaged to provide. Lane Clark & Peacock UAE operates under legal name Lane Clark & Peacock Belgium Abu Dhabi, Foreign Branch of Belgium. Lane Clark & Peacock LLP 2014.