With Profits Section Presentation to employers

1. With Profits SectionPresentation to employers

2. Agenda • Background to the With Profits Section • Legislative background and engagement with the Department for Work and Pensions • The impact of the new legislation • Funding position • What it means for employers • Investment strategy • Questions Employers’ meeting June 2014

3. Conflicts • Trustee is made up of 13 individuals, six representing employers, six representing members and one co-opted director. There is currently one employer vacancy. • Many of the employer representatives have employees or previous employees with benefits in the With Profits Section. • Some Trustee Board members are also members of the With Profits Section themselves. • All conflicts are declared and recognised in any discussions. Employers’ meeting June 2014

4. Background to the Cheviot pension • With Profits Section (established in 1930): Money Purchase Section (established in 2000). • Industry wide arrangements set up and administered as money purchase (or defined contribution) arrangements where contributions from employers are limited to those agreed between them and their employees and are allocated directly for the benefit of those employees. • The Money Purchase Section continues to accept new contributions, is available for auto enrolment and is not affected by the change in legislation. It provides investment returns linked directly to the value of the assets. The assets are held separately to the assets of With Profits Section. • The With Profits Section is run on a mutual basis. All benefits and assets are pooled and the intention was to provide smoothed investment returns through a interest and bonus mechanism. • It is not sectionalised by employer. Employers’ meeting June 2014

5. With Profits Section • The Section originally operated as a deferred annuity arrangement. Members earned a future pension, payable from the Section, relative to each contribution. • In 1988, the Section converted to a cash accumulation basis for all members who had not yet retired for both past and future contributions and provided guaranteed rates of return ranging from 3-5% per year depending on when the contributions were made. Many members have contributions with different guaranteed rates of return. • The Section closed to new contributions from 2003. • Bonuses payable at the discretion of the Trustee when returns allow. • Only members who retired before July 2005 had the option to take an internal pension • Some pensions have no increases or increase with bonuses only (so no increases since 2001) • Some pensions increase by Limited Price Indexation (CPI up to 5% per year) but may have been expecting bonuses in addition where funding permitted (no bonuses declared since 2001) Employers’ meeting June 2014

6. With Profits Section • The Section has always been run on the basis that contributions from employers were limited to those agreed with members. There was no expectation that employers would contribute more generally to any deficit. • Providing guarantees in some form has been part of the Section since it was established in 1930. The Trustee has taken steps to change the nature and level of the guarantees where it has been able to do so, usually only for future contributions. • The Trustee has commissioned regular actuarial reviews to consider the funding position to enable it to make decisions about bonuses. Annual bonuses were declared on the basis of smoothed returns over a three year period. • Members’ accounts may be reduced in exceptional circumstances. Employers’ meeting June 2014

7. With Profits Section • The Trustee decided to close the Section to new contributions at the end of 2002. • This decision was based on: • Sharp falls in gilt yields and an increase in life expectancy which meant the reserve for pensioners needed to be increased • The increase in the reserve made it less likely that the Section would be able to declare bonuses in the future • The future investment returns available to members were therefore likely to be reduced and less attractive as a result • The transfer value basis was changed at the same time to exclude the potential for future bonuses. This means that the amount available for transfer is usually less than a member’s account as it includes an allowance for future investment returns. The basis is reviewed monthly by the Actuary for reasonableness in light of market conditions. • The facility to secure a pension from the Section was withdrawn in 2005. Employers’ meeting June 2014

8. Agenda • Background to the With Profits Section • Legislative background and engagement with the Department for Work and Pensions • The impact of the new legislation • Funding position • What it means for employers • Investment strategy • Questions Employers’ meeting June 2014

9. Legislative background • The Supreme Court judgment in the Bridge case upheld Cheviot’s analysis of majority of the benefits provided by the With Profits Section as money purchase benefits on 27 July 2011. • Some uncertainty remained about a small proportion of the benefits but these have now been bought out. • Late amendments were introduced to the Pensions Bill 2011 to change the definition of a money purchase scheme from that considered in the Bridge case. The new definition was to be brought into force by regulations. The new definition means that the With Profits Section will no longer be a money purchase scheme and will be subject to statutory funding requirements. • The Department for Work and Pensions’ objective was to extend the funding regime retrospectively to 1997 to all schemes which are capable of having a funding deficit, to protect members and to comply with their view of the UK’s obligations under European Directives. Employers’ meeting June 2014

10. Discussions with the DWP • The Trustee engaged with the DWP in conjunction with the employers’ group. The key issues have been: • The complexities of the Cheviot arrangements • The lack of impact assessment in relation to the change in legislation which meant that the impact on employers was not recognised before the legislation was passed • The very significant impact on employers and the potential for it to damage a large number of small businesses • The potential for litigation which would damage the funding position of the Section and lead to less security for members • The difficulty of identifying employers and collecting contributions in a cost effective way Employers’ meeting June 2014

11. Discussions with the DWP • Both the Trustee and employers lobbied extensively. • About 50 MPs wrote to Steve Webb, Pensions Minister, about the issue, thus forcing a formal response to our questions. • Cheviot’s MP was helpful in securing a meeting with the Minister. • A series of meetings with the DWP officials were held. • Conclusions were: • Ultimately a refusal by the Department to consider any carve out for Cheviot • An acceptance that the issues were difficult for us • A reasonably comprehensive carve out from the retrospective elements of the regulations. • As a result, although we are obliged to comply with the new requirements from July 2014, we have the opportunity to avoid the difficulties and complexities of having to revisit decisions made since 1997. Employers’ meeting June 2014

12. Current position • The regulations to bring the new definition into force were laid on 6 May 2014 and are expected to come into force on 14 July 2014. The With Profits Section will be subject to Scheme Funding requirements from that date. • The impact assessment is now much more comprehensive and runs to 29 pages which detail each of the main areas in turn and explains the action taken in respect of them in the legislation (mostly to remove the retrospective nature of the change). • The regulations introduce wider transitional exemptions from those provided in the consultation draft, although the Cheviot arrangement does not fall neatly into their definitions. Our initial view is that the transitional exemptions work in most cases but this is subject to further review. • A note of our initial view of the impact of the regulations is available Employers’ meeting June 2014

13. Agenda • Background to the With Profits Section • Legislative background and engagement with the Department for Work and Pensions • Impact of new legislation • Funding • What it means for employers • Investment strategy • Questions Employers’ meeting June 2014

14. Impact of the new legislation • The change in legislation means that the With Profits Section will no longer fall within the definition of money purchase scheme but within a new definition of benefits: “cash balance benefit” is a sum of money (“the available sum”) available under the scheme for the provision of the benefit to or in respect of the member. There is a promise about the amount of the available sum but there is no promise about the rate or amount of any pension to be provided from the available sum. • Schemes providing cash balance benefits are subject to the Scheme Funding Requirements. • The Section is a multi employer non segregated arrangement. This means that all the benefits under the section are valued together - they are not split by employer although Cheviot may provide figures on this basis for illustrative purposes. Employers’ meeting June 2014

15. Agenda • Background to the With Profits Section • Legislative background and engagement with the Department for Work and Pensions • Impact of new legislation • Funding • What it means for employers • Investment strategy • Questions Employers’ meeting June 2014

16. Funding requirements • Any scheme which is not a money purchase scheme must comply with Scheme Funding regulations. • Scheme Funding requires: • Formal valuation every three years with interim annual updates • Benefits valued on prudent basis reviewed at each formal valuation • Financial assumptions must be market consistent and related to investment strategy • Strength of basis linked to covenant of the employers • If a deficit is revealed, implement a recovery plan to restore 100% funding within recovery period which may include contributions from employers • Recovery plan can be based on less cautious investment assumptions Employers’ meeting June 2014

17. Funding requirements • The objective is to ensure there is a reasonable expectation of the Section being sufficiently well funded to provide the promised benefits. • The Scheme Actuary carries out a valuation: • Ensures the data is consistent with the data at previous valuations and then uses it to calculate the funding position • Discusses the appropriate assumptions to use for assessing the cost of providing the benefits with the Trustee including: • Investment risk and returns • Mortality expectations • Covenant and regulatory risk • Trustee propose basis to employers, including any recovery plan where the Section is not fully funded. Complete and submit documentation to the Pensions Regulator Employers’ meeting June 2014

18. Latest valuation • The Trustee commissioned a valuation at 31 December 2013. This is not a formal scheme funding valuation • The Trustee has looked at a range of assumptions which target a funding level which would allow the investment risk to be reduced significantly. Employers’ meeting June 2014

19. Assumptions • The range of assumptions considered included: • Increasing the assumed return from investment during the on risk period • Increasing the assumed return from less risky assets during the self sufficiency period • Variables in potential expenses • Results varied from a funding level of 100% with a surplus of £0.5m to a funding level of 106% with a surplus of £6.4m • All these numbers rely on future investment returns being as assumed for 9 or 10 years. Employers’ meeting June 2014

20. Valuation results Employers’ meeting June 2014

21. First valuation under the new Regulations • The timescale for producing and agreeing a valuation is 15 months from the date of the valuation. • The Regulations provide that the effective date of the first valuation needs to be within 12 months. The valuation date will be 31 December 2014 as Cheviot’s year end. • The valuation needs to be completed within 6 months. This is a much shorter timescale than usual. • As a result, we are having consider how best to manage the process and will undertake some of the work in advance of the valuation date. Employers’ meeting June 2014

22. Proposed Cheviot Valuation process January 2015 June 2015 Employers’ meeting June 2014

23. Proposed approach • The timescale set out in the regulations is very tight and the consequences of not complying are very significant as the Section would not fall within the exemption set out in the Regulations to avoid the retrospective effect of the legislation. • Given the issues in terms of identifying the statutory employers, this is even more challenging for Cheviot. • The Trustee is arranging a meeting with the Pensions Regulator to discuss the implications but the Regulator will be constrained by the Regulations. • The Trustee has power under the Rules “To the extent permitted by law, the Trustee shall have power to make all decisions, including acting on behalf of a Participating Employer, in connection with decisions required by the 2004 Act in relation to the funding status of a Final Salary Scheme and the Cheviot Pension, to include (without limitation) the statement of investment principles and the scheme - specific funding basis.” • Leading Counsel has advised that it is reasonable for the Trustee to use this power to settle the valuation after consulting with employers on the basis. Employers’ meeting June 2014

24. Proposed timescale • Very short timescale • Will require co-operation from employers in advance and during the 6 month window • Consequences of non compliance are extremely serious Employers’ meeting June 2014

25. Agenda • Background to the With Profits Section • Legislative background and engagement with the Department for Work and Pensions • The impact of the new legislation • Funding position • What it means for employers • Investment strategy • Questions Employers’ meeting June 2014

26. What this means for employers? • Assuming that the funding levels continue to improve and investment returns meet the Actuary’s assumptions, it is unlikely that employers will be required to make contributions but it remains a possibility. • The issues that will impact on this are: • actual investment returns • costs of considering the impact of the new legislation • general running costs will increase as the regulatory burden is greater under the new requirements. • identification of employers • Pension Protection Fund levy Employers’ meeting June 2014

27. Identification of employers • Statutory Employerswill become legally responsible to support the funding of the section under Part 3 of the Pensions Act 2004. This may have an impact on the employer’s financial statements (particularly LLPs). • 169 Statutory Employers are defined as those who were contributing when the Section closed to new contributions at the end of 2002 and still have liabilities in the Section. The regulations are not clear how this definition applies to partnerships. Many Statutory Employershave a complicated history since 2002. We are taking a pragmatic approach of corresponding with the current firm. • Statutory Employers will be responsible for liabilities relating to their employees who still have benefits under the Section and also a share of any orphan liabilities. • Orphan liabilities relate to employers who stopped participating before 2002 (660 Contractual Employers) but whose members still have benefits in the arrangement. • The Trustee is considering introducing a contribution rule to enable it to share any funding burden amongst a wider group of employers, including both Statutory and Contractual employers, whose members still have benefits in the Section. Employers’ meeting June 2014

28. Pension Protection Fund levy • The Pension Protection Fund provides support for members whose employers are unable to financially support their pension scheme • With Profits Section is very unlikely to be eligible as in a multi-employer scheme all employers would be required to be bankrupt. • But current regulations require us to submit valuations and pay a PPF levy going forward • The level of levy depends on: • The level of funding of the arrangement • The strength of the covenant supporting it as assessed by Experian • Our concerns: • The uncertainty of identifying the statutory employers • The nature of partnerships • Range of levy - £30k – £400k per year depending on these factors Employers’ meeting June 2014

29. PPF levy • We are considering a number of options for reducing or eliminating the PPF levy. • Meeting with the PPF to discuss what flexibility they have to reflect our unusual circumstances • Challenging whether we should pay it when there is no prospect of us being eligible • Discussing with employers (probably the successor in business) the possibility of providing PPF guarantees in respect of their liabilities which would improve the covenant Employers’ meeting June 2014

30. What this means for employers • You now have obligations in respect of the benefits in the With Profits Section whether on a Contractual or Statutory basis. • Your auditors may require you to disclose the potential liabilities in your accounts through the inclusion of FRS17 numbers. • You will need to provide regular financial information to the Trustee of the With Profits Section • Trustees are required to monitor the covenant of employers • Scheme Administration regulations give the Trustee authority to request the information • If you change corporate structure, through an LLP conversion, merger etc. you must consult with the Trustee in advance to discuss how the obligation will be supported in the future and to avoid triggering a debt (which would be for the full buy out cost). This applies even though there is no current requirement to make additional contributions. Employers’ meeting June 2014

31. Regulatory Considerations for Employers Moral Hazard Powers of the Pensions Regulator • Financial Support Directions and Contribution Notices • Connected and Associated parties e.g. A person is an associate of any person with whom he is in partnership. • Any decision by the employer to take action which will, or is intended to, result in a debt which is or may become due to the scheme not being paid in full. • A decision by the employer to cease to carry on business in the United Kingdom, or where the employer ceases to carry on business in the United Kingdom without such a decision having been taken, the cessation of business in the United Kingdom by that employer. • Any breach by the employer of a covenant in an agreement between the employer and a bank or other institution providing banking service, other than where the bank or other institution agrees with the employer not to enforce the covenant. • The conviction of an individual, in any jurisdiction for an offence involving dishonesty, if the offence was committed while the individual was a director or partner or the employer. Notifiable events Employers’ meeting June 2014

32. Regulatory Considerations for Employers Incentive exercises (e.g.enhanced transfer value exercises) • Pensions Regulator Statement July 2012 • “Trustees should start from the presumption that incentive exercises are not in most members’ best interests”, and should actively engage with members to ensure they are properly informed • Pensions Regulator will investigate reports of cases where behaviours give rise for concern – e.g. “coercing or placing undue pressure on members to transfer or give up their benefits”. Employers’ meeting June 2014

33. Regular information from Cheviot • Quarterly funding information reflecting investment performance and changes in financial conditions but not updating the member data • Annual liability figures. There are a number of different bases used to produce the liability figures. The two keys ones are: the Statutory position based on Statutory Employers only and the Contractual position based on all employers. The main difference between the two is the level of orphan debt. • FRS17 figures are only likely to be required for Statutory Employers and these will be produced at 31 December, 31 March and 30 April each year. These are produced on a different set of assumptions. • Statutory accounts produced annually and available on the website • Asset allocation information available monthly on the website • Annual employers’ meeting Employers’ meeting June 2014

34. Funding update Employers’ meeting June 2014

35. Investment issues Employers’ meeting June 2014

36. Questions Employers’ meeting June 2014