Volume 2020 | Issue 09
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The Pensions Regulator has published the first of two consultations in what promises to be a game changing overhaul of defined benefit (DB) pension scheme funding.
Whilst being mindful of the cost to employers of running their DB schemes and wanting to avoid negatively impacting jobs and investment, this consultation could trigger a tougher regime for employers who seek to push the boundaries of the
flexibilities in the current regime. There is the potential for higher deficit recovery contributions and lower investment risk strategies.
The consultation was due to run until 2 June 2020, but has been extended to 2 September 2020 due to COVID-19. Between now and then the Regulator will be meeting with industry representatives to discuss the proposals and is holding a number of stakeholder events in March.
Background
In a 2018 white paper the government noted that the defined benefit (DB) funding framework was working largely as intended. However, it also acknowledged that there was room for improvement in some key areas, for example the need for greater transparency and accountability around risks being taken on behalf of members and employers, and for trustees to focus on the long-term strategic issues for their scheme as the landscape matures.
It also highlighted some grey areas in the existing framework relating to how DB trustees should set their scheme’s technical provisions (TPs) prudently and an appropriate recovery plan (RP). This lack of clarity has enabled a minority of schemes and employers to misuse the flexibility in the system and made it more difficult for us to regulate DB schemes efficiently.
Following new measures introduced in the Pension Schemes Bill the Regulator has published the first of two consultations to address these concerns.
The first consultation was billed by the Regulator as one that would look at the mechanics of the proposed new regulatory approach and the principles underpinning the new framework, and how they could be applied in practice to provide clearer guidelines. The second consultation, scheduled for later in the year, is to consider the new draft code itself.
The consultation, published on 3 March 2020 and 175 pages long, contained much more than was expected.
Bad practice
The Regulator has identified a range of bad practice from poor risk management to inappropriate use of the flexible scheme-specific regime, such as:
- imprudent TPs (i.e. weak funding targets which assume a level of risk that cannot be supported and result in artificially low deficits)
- double-counting of the covenant: TPs are weak (resulting in lower deficits) because the strong covenant can support more risk while the RP is also long because it is claimed the strong covenant can give trustees more comfort about the affordability of future deficit repair contributions (DRCs)
- reasonable TP assumptions but an inappropriately risky investment strategy
- reasonable TPs with RPs overly-reliant on investment outperformance (therefore unwinding some of the prudence from the TPs in the overall funding strategy)
- unfair treatment compared to other stakeholders such as the trustees being asked to accept a very long RP while significant dividends are being paid out
- significantly back-end loaded RPs, which may be pushed out again at the next valuation
- short-term focus, with closed schemes setting the discount rates based on the current investment strategy with no allowance for any likely future changes in that strategy
- short-term focus on DRCs over the next three years and lack of contingency planning (banking on higher DRCs being negotiated at the next valuation)
- reliance on additional support that doesn’t provide the comfort it claims to offer (e.g. a guarantee from a strong company being assumed to provide a strong covenant indefinitely, or reliance on a contingent asset that does not have real value when needed), and
- trustees unable to justify how the risks the scheme is taking are being managed.
Whilst the new code will not come into force until next year, trustees undertaking valuations would do well to take note of the issues the Regulator considers bad practice.
Key valuation principles
The Regulator has identified a number of overarching principles that trustees should adopt at scheme valuations.
| Compliance and evidence |
| · Trustees and employers are expected to be able to understand their scheme-specific funding and investment risks and objectively evidence how these risks have been supported and/or mitigated). Robust evidence should be provided when risks are genuinely unsupportable.
· When demonstrating how risks are managed, trustees should be able to compare the risks they have taken to a tolerated risk position and then demonstrate the mitigation and/or support available. |
| Long-term objective (LTO) |
| · By the time they are significantly mature, schemes are expected to have a low level of dependency on the employer and be invested with high resilience to risk. |
| Journey plans and technical provisions (TP) |
| · Trustees are expected to develop a journey plan to achieve their LTO.
· Trustees are expected to plan for investment risk to decrease as their scheme matures and reaches low dependency. · TPs should have a clear and explicit link to the LTO, and over time, should converge to the LTO as evidenced by the journey plan. |
| Scheme investments |
| · The actual investment strategy and asset allocation over time should be broadly aligned with the scheme’s funding strategy (TPs and RP).
· Trustees must ensure their investment strategy has sufficient security, sufficient quality, and can satisfy liquidity requirements based on expected cash flows as well as a reasonable allowance for unexpected cash flows. · The asset allocation is expected at significant maturity to have high resilience to risk, a high level of liquidity and a high average credit quality. |
| Reliance on the employer covenant |
| · Schemes with stronger employer covenants can take more risk and assume higher returns.
· However, trustees should assume a reducing level of reliance on the covenant over time, depending on its visibility. |
| Reliance on additional support |
| · Schemes can account for additional support when carrying out valuations provided that it:
o Provides sufficient support for the risk(s) being run o Is appropriately valued, and o Is legally enforceable and realisable at its necessary value when required. |
| Appropriate recovery plans |
| · TP deficits should be recovered as soon as affordability allows, while minimising any adverse impact on the sustainable growth of the employer. |
| Open schemes |
| · Members’ accrued benefits in open schemes should have the same level of security as members’ accrued benefits in closed schemes. |
Fast track and bespoke
The Regulator is intending to introduce a twin-track approach to carrying out valuations. Trustees will have to submit evidence to the Regulator whichever approach they adopt demonstrating their approach to managing their funding and investment risks as part of the new statement of strategy introduced in the Pension Schemes Bill. Those adopting a bespoke approach would be subject to greater scrutiny.
Trustees adopting one approach don’t have to adopt the same approach at the next valuation.
Fast track
For fast-track valuations the Regulator will set straightforward quantitative compliance guidelines for trustees to ensure their valuation is compliant with legislation. Thereafter, trustees can expect minimum regulatory involvement on funding.
The fast-track approach is expected to ease the process for well-funded and well-run schemes.
Bespoke
For bespoke valuations trustees and employers will have more flexibility to account for the specific circumstances of the scheme and employer. Decisions will, however, have to be fully articulated and evidenced and may mean a higher regulatory involvement.
The Regulator stresses that it does not view bespoke valuations as bad or a second-best option.
Employer covenant
The Regulator is querying how much reliance at valuations should be put on employer covenant and the degree to which it is reasonable for pension scheme members to be subject to employer insolvency risk. Whilst totally insulating scheme members is seen as too costly, where to strike the balance will be a key theme in the second consultation on the funding code, to be published later this year.
The proposal is, however, that some limit should be placed on covenant visibility which should not typically extend beyond the short to medium term of three to five years. Consideration is also being given to moving from a holistic approach to a more formulaic calculation or metric.
Long term objective (LTO)
The Pension Schemes Bill sets out a requirement for trustees to set an LTO, described as a funding and investment strategy in the Bill. In setting this strategy the expectation is that schemes will progressively reduce their reliance on the employer covenant over time to reach a level of low dependency funding combined with investments that are highly resilient to risk by the time they are significantly mature. This will enable trustees to pursue end-game strategies in due course.
The Regulator’s initial view is that a low dependency discount rate would be somewhere in the range of Gilts plus 0.5% to Gilts plus 0.25% p.a. and that significant maturity would be 15 to 20 years from now, for a scheme of average maturity.
Technical provisions are a way of measuring progress towards the LTO and will, therefore, reflect the discount rates during the journey and how investment strategy is incorporated. Thus, TPs should be consistent with the LTO.
Scheme investments
A scheme’s investment strategy and asset allocation over time should broadly align with the funding strategy including consideration of the TPs and journey plan.
Trustees should ensure investment risk should be measured, satisfy liquidity requirements, be appropriate and supported.
Recovery plans
Affordability to the sponsoring employer(s) should be the key consideration. Any affordability constraints have to be evidenced and trustees should then seek suitable and realisable mitigations.
Comment
The Regulator does not anticipate that the new regime will be too onerous for most schemes but accepts it will have a significant impact on others.
The second consultation later this year will follow the publication of draft regulations by the DWP which will set out the detailed requirements set out in the Pension Schemes Bill. The Regulator will use the legislation, and the feedback from the industry on the first consultation, to inform its second consultation on the draft funding code. The revised code and the regulations are expected to come into force at the end of 2021.
This is not simply a restatement of existing practice by the Regulator and looks to be a significant overhaul of DB funding.