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Consultation on the Pensions Regulator’s new DB Funding Code - What you need to know

  • United Kingdom
  • Pensions

03-03-2020

The Pensions Regulator has published the first of its long awaited consultations on a new DB Funding Code. This consultation covers the principles underpinning the Regulator’s approach. A second consultation will follow later in the year on the details of the new Code itself.

The new Code will set out clearer parameters for trustees to follow in the valuation process and reflect the need to take long term strategic issues into account.

The Regulator has stated that the lack of clarity around “what good looks like” makes enforcement action around scheme funding very difficult and the new regime should also address that.

The Regulator is aiming to “create a sustainable framework, which provides the right balance between the security of member benefits and the costs to employers of running their DB schemes”.

Key principles

Based on its experience to date, the Regulator has identified a number of overarching principles which it believes should underpin all scheme valuations. These include:

Compliance and evidence: Trustees and sponsors should understand funding and investment risks. Trustees should be able to demonstrate how risks are managed and compare any risks taken with a “tolerated risk position” (set out in the fast-track funding approach – see below).

Long term objective (“LTO”): Mature schemes should have a low level of dependency on the employer and be resilient to risk.

Journey plans and technical provisions: Trustees should have a journey plan to achieve their LTO and should aim for investment risk to decrease as the scheme matures and reaches low dependency. Technical provisions should have a clear and explicit link to the LTO.

Investment: Investment strategy and asset allocation should be broadly aligned with the scheme’s funding strategy. The Regulator expects the asset allocation in a mature scheme to have high resilience to risk, a high level of liquidity and a high average credit quality.

Employer covenant: Schemes with stronger employer covenants can take more risk and assume higher returns but trustees should assume a reducing level of reliance on the covenant over time.

Additional support: Trustees can take into account any additional support for the scheme (such as parent company guarantees) in valuations if it provides sufficient support for the risks being run, is appropriately valued, legally enforceable and realisable when required. Trustees should not automatically assume that a guarantee used for PPF levy purposes is appropriate for funding purposes as contingent assets supporting scheme funding may need to cover additional amounts and potentially a broader range of circumstances.

Recovery plans: Deficits should be recovered as soon as affordability allows, whilst minimising any impact on the sustainable growth of the employer.

Open schemes: Active members should have the same level of security as deferred members in closed schemes. Trustees who use a different approach to funding because the scheme is open to future accrual would need to explain why this is appropriate in terms of the employer’s plans and the future covenant strength.

Bespoke and fast track approaches

To achieve greater clarity around funding, the Regulator believes that there needs to be an “objective” funding standard. Crucially, this standard will not aim to eliminate all funding risk but will set out how risks should be measured and managed. At the same time, the Regulator does not want to repeat the mistakes of the past by adopting some kind of prescriptive MFR 2 regime.

Therefore, it has proposed a twin track approach with a fast-track “objective” funding option and a bespoke, scheme specific alternative.

Fast-track approach

  • Follow guidelines on LTO, assumptions, investment risk, recovery plan length and structure and contribution rates
  • This may mean using a discount rate of between gilts +0.5% and gilts +0.25%
  • Take into account some scheme specific factors such as covenant strength and scheme maturity
  • Sets a baseline of tolerated risk
  • Recovery plans may need to be a standard length (possibly around 6 years) or might vary depending on covenant strength (possibly between 6 and 12 years)
  • Reliance on employer covenant limited to 3-5 years
  • Likely to result in minimal engagement with Regulator on funding

Bespoke approach

  • Use own assumptions to reflect scheme circumstances
  • Basis for decisions will need to be evidenced
  • Much more detail needed in funding and investment strategy statement
  • Tested against the fast-track
  • Trustees will need to evidence mitigation for any additional risks taken
  • May result in more Regulator engagement
  • This is not intended to be seen as a worse alternative than the fast-track approach

The Regulator anticipates that schemes might want to adopt the bespoke approach where trustees consider that it is appropriate to take additional risks or where the employer covenant is so weak that a scheme cannot meet some or all aspects of the fast-track. Trustees adopting one approach at one valuation would not be tied to using the same approach at the next valuation.

When schemes choose to use the bespoke approach, the Regulator will consider:

  • how the funding code and relevant legislation have been complied with;
  • the extent to which the valuation diverges from the fast-track;
  • how additional risk (if any) is being managed (eg additional support or mitigation); and
  • the quality of the supporting evidence provided by the trustees.

Whichever approach is used, trustees will also be expected to follow all of the key principles set out above.

The new funding and investment strategy statements which trustees will be required to prepare and submit to the Regulator under the Pension Schemes Bill (in consultation with employers) will form part of this twin track approach. Where trustees are using the fast-track, the statement should be fairly straightforward and include basic information on the valuation and approach to risk management. Where a scheme is using a bespoke approach, the statement will need to set out the funding arrangements in detail and explain how and why the trustees have moved away from the fast track and how they are managing any additional risk.

This requirement for trustees to set out their position relative to the fast-track requirements effectively puts the onus on them to demonstrate that they have complied with their legal obligations in relation to scheme funding. This is intended to enable the Regulator to intervene in a more effective way and make it easier for it to exercise its scheme funding powers.

What next?

This consultation closes on 2 June 2020 and a second consultation on the draft code is due later this year. Sponsors and trustees should consider whether to respond to the consultation as it represents a significant change to the current funding regime and could have significant implications for some schemes.

The Regulator anticipates that the new Code together with the changes to the scheme funding regime set out in the Pensions Schemes Bill will come into force at the end of 2021.

Schemes with valuation dates in late 2021 and 2022 will need to watch closely how these proposals evolve so they can factor them into their valuation approaches quickly.

More generally, all DB schemes should be giving some consideration to whether they will want to adopt the fast-track or a more bespoke route for future valuations. Trustees will need to talk to the scheme actuary and in most cases, the scheme sponsor, about how appropriate the fast-track assumptions are for their scheme and whether there are any justifications for using a bespoke approach.

Trustees also need to be giving thought now as to what their long-term journey plans are likely to look like and the extent to which they are reliant on the sponsor.

 

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