BAE Systems 177 Annual Report 2017 21. Retirement benefits continued Contributions Under the terms of the trust deeds of the UK schemes, the Group is required to have a funding plan determined at the conclusion of the triennial funding valuations. Equity accounted investments make regular contributions to the schemes in which they participate in line with the schedule of contributions and are allocated a share of deficit funding contributions. In 2017, total contributions to the Group’s pension schemes were £433m (2016 £461m), including amounts funded by equity accounted investments of £31m (2016 £50m), and included approximately £209m and £62m of deficit recovery payments in respect of the UK and US schemes, respectively. Based on the new funding valuations, current annual deficit recovery payments to the UK schemes, including amounts funded by equity accounted investments, will increase to £220m a year from 1 April 2018. Deficit contributions will further increase in line with any percentage growth in dividend payments made by the Group. Under the new deficit recovery plans, these annual payments would subsequently fall by £50m in 2022 as the deficits on certain schemes are expected to be cleared. The annual payments are expected to end in 2026 when all deficits are projected to be cleared. Under the last agreement made in 2014, all scheme deficits were projected to be cleared in 2026. Based on the latest valuations of the Group’s US pension schemes, contributions are expected to remain at a level consistent with 2017 through to 2022. In 2018, the Group expects to make total contributions to its pension schemes of £0.5bn. Risk management The defined benefit pension schemes expose the Group to actuarial risks, including market (investment) risk, interest rate risk, inflation risk and longevity risk. Risk Mitigation Market (investment) risk The investment portfolios are highly diversified, investing in a wide range of assets, in order to provide Asset returns may not move reasonable assurance that no single security or type of security could have a materially adverse impact in line with the liabilities and on the total portfolio. To reduce volatility, certain assets are held in a matching portfolio, which largely may be subject to volatility. consists of index-linked bonds, gilts and swaps, designed to mirror movements in corresponding liabilities. Some 47% (2016 47%) of the Group’s pension scheme assets are held in equities and pooled investment vehicles due to the higher expected level of return over the long term. Some of the Group’s pension schemes use derivative financial instruments as part of their investment strategy to manage the level of market risk. The Main Scheme has a long-dated equity option strategy protecting £1.4bn of assets against a significant fall in equity markets. Interest rate risk In addition to investing in bonds as part of the matching portfolio, some of the UK schemes invest in Liabilities are sensitive to interest rate swaps to reduce the exposure to movements in interest rates. The swaps are held with several movements in interest rates, banks to reduce counterparty risk. with lower interest rates leading The discount rate assumptions set as part of the 2017 UK funding valuations more directly reflect the to an increase in the valuation expected returns on assets held by the schemes and, therefore, the liabilities are less sensitive to interest of liabilities. rate risk than they were in the 2014 funding valuation. Accordingly, the 2017 approach provides a more natural hedge against interest rate risk. The planned investment strategy, which is reflected in the discount rate and liability calculation, is for the schemes to increase their investments in bonds or other assets which match the liabilities as the schemes mature. Under the 2017 UK funding valuation, the Group expects the schemes to be fully hedged against interest rate movements following a five-year transition period to the planned investment strategy. Inflation risk In addition to investing in index-linked bonds as part of the matching portfolio, the principal UK schemes Liabilities are sensitive to invest in long-term inflation swaps to reduce the exposure to movements in inflation. The swaps are held movements in inflation, with with several banks to reduce counterparty risk. The Group’s US schemes are not indexed with inflation. higher inflation leading to The approach to the 2017 UK funding valuation provides a more natural hedge against inflation an increase in the valuation movements and, therefore, the liabilities are less sensitive to inflation risk than they were in the 2014 of liabilities. funding valuation. Under the 2017 UK funding valuation approach, the Group is already fully hedged against inflation movements and, under the planned investment strategy, the Group aims to maintain a fully hedged position. In 2014, the Main Scheme implemented a pension increase exchange to allow retired members to elect for a higher current pension in exchange for foregoing certain rights to future pension increases. Longevity risk Longevity adjustment factors are used in the majority of the UK pension schemes in order to adjust Liabilities are sensitive to the pension benefits payable so as to share the cost of people living longer with employees. life expectancy, with increases In 2013, with the agreement of the Company, the trustees of the 2000 Plan, Royal Ordnance Pension in life expectancies leading Scheme and Shipbuilding Industries Pension Scheme entered into arrangements with Legal & General to an increase in the valuation to insure against longevity risk for the current pensioner population, covering a total of £4.4bn of pension of liabilities. scheme liabilities. These arrangements reduce the funding volatility relating to increasing life expectancy.