DB funding code consultation

United Kingdom

Today the Pensions Regulator (“TPR”) has published its first consultation on a new funding code for defined benefit pension schemes. This seeks views on the general approach and principles. TPR expects the revised code to come into force in late 2021. Many of the themes in the consultation reflect existing practice, but the new requirement for a long-term objective and the proposed twin-track compliance approach will require some careful consideration from trustees and their advisers.

A second consultation, in late 2020, will contain the proposed text of the code and further detail on enforcement. The consultation runs to 175 pages and asks 58 specific questions and will require detailed consideration in the coming weeks, with consultation closing on 2 June 2020.

Looking to the long term

Under-pinning the new approach is the requirement, as set out in the current Pension Schemes Bill, for trustees to set a long-term funding and investment strategy. TPR refers to this as the long-term objective (“LTO”) and proposes that a scheme’s LTO should be to reduce reliance on the employer covenant over time to reach a position of “low dependency” by the time the scheme reaches “significant maturity” where there is a low chance of requiring further sponsor support and the investment strategy is highly resilient to risk. This should give trustees a good platform to pursue “end game” strategies such as buy-out, transferring to a consolidator or continuing to run the scheme on a low risk basis. Various ways of measuring significant maturity are suggested, with the favoured one being the “duration of liabilities” method where the mean term of the liabilities is weighted by future cash flows (many scheme actuaries will already do this calculation as part of the actuarial valuation).

It’s all about the journey

Once trustees have set an LTO then they will be expected to develop a journey plan to get there, using the technical provisions set at each valuation as steps on the journey. As TPR expresses it, “the LTO is the destination, the technical provisions are the journey milestones”. Trustees should identify and put plans in place to manage risks which might throw the journey-plan off course and put in place processes to regularly monitor those risks.

Fast Track or Bespoke

Trustees will have the choice of adopting a Fast Track or Bespoke route to compliance. Under Fast Track, TPR will set a series of objective and quantitative guidelines (with the detail to be considered in the second consultation) which may include setting the LTO by defining the low dependency discount rate (and possibly other assumptions) and the timing of significant maturity, as well as prescribing for each actuarial valuation the technical provisions funding, recovery plan length and investment risk based on a scheme’s maturity and employer covenant. Trustees who can submit a valuation which is compliant with all the guidelines will be on the Fast Track and can expect to receive “minimal” regulatory scrutiny.

The Bespoke route is available for trustees who cannot satisfy the Fast Track guidelines or who choose not to do so (perhaps because they want to take additional risk). Bespoke arrangements should still meet the key principles (including having an LTO and journey plan) but will receive more regulatory scrutiny. Trustees taking more risk would be expected to provide evidence of how it is managed and to assess any additional support robustly.

Relying on the employer covenant

The consultation considers the extent, if at all, to which members should be subject to employer insolvency risk. TPR takes the pragmatic view that fully insulating schemes from insolvency risk would be too costly and that trustees should continue to be able to place some reliance on covenant. The consultation asks whether the current “holistic” approach to assessing covenant should be retained (where trustees have flexibility in weighing up scheme and employer-specific factors) or whether a new “formulaic” approach should be adopted. If the holistic approach is to be retained then there will be new, more detailed TPR guidance on it.

Aligning investment risk with funding strategy

TPR proposes that the new code will require trustees to align their investment strategy and asset allocation over time with the scheme’s funding strategy. As outlined above, this would mean a scheme reaching significant maturity should have a high resilience to risk as well as a high level of liquidity. The consultation looks in detail at how the appropriate level of investment risk should be measured and defined for the Fast Track guidelines. It is proposed that there will be a “pass or fail” test to assess whether a scheme complies with the investment risk guidelines – if it fails then trustees will have the choice of reducing the level of risk to bring it within the guidelines or demonstrating through the Bespoke route how they intend to support the increased risk.

Recovery plans and equitable treatment

TPR proposes that trustees should seek to agree a recovery plan “as short as employer affordability allows, provided doing so does not impede the employer’s sustainable growth”. The consultation focusses on the key elements which should make up a compliant recovery plan for the Fast Track process. One proposal includes very clear limits on recovery plan length, depending on the strength of the employer covenant, with the maximum proposed length of 12 years for a weak employer. TPR asks whether a much shorter length (perhaps only three years) would be appropriate where the employer covenant is strong. A key principle is that there should be consistency between the strength of covenant assumed in the technical provisions and the length of a recovery plan – where these do not match up then the trustees will have to submit a Bespoke valuation and demonstrate why the recovery plan needs to be longer. There is also a suggestion that Fast Track could prohibit “back-end loading” of recovery plans.

Recently, TPR has been concerned that schemes are treated equitably compared to other stakeholders and creditors of the employer, both in business as usual situations and exceptional distributions. TPR proposes to set out clear expectation on this in the code. It would be less concerned with business as usual dividends in relation to recovery plans within the Fast Track limits for stronger employers but would be unlikely to recognise the need to pay a dividend as a reasonable justification for an over-long recovery plan.

The Consultation document can be found here.