The UK Pensions Regulator’s (TPR) consultation on a new Code of Practice for funding defined benefits (DB) pension schemes has just closed.
This was the first of two consultations on the new Code, which represents a significant change in approach for the regulation of DB scheme funding.
This first consultation focused on principles, while the second will delve into the detailed figures and limits that will form the framework around the new Code.
Fast track vs bespoke
The consultation introduces the fast track vs bespoke approach. Schemes whose funding and investment strategy fall within fast track boundaries will be subject to little regulatory interaction. The framework will provide flexibility for schemes that are doing something different, provided they can justify it through the ‘bespoke’ track – which will mean more regulatory scrutiny.
The rationale behind this twin track system is to provide clarity around TPR’s expectations and to reduce the cost of regulatory compliance for schemes adopting fast track, while retaining some flexibility in the system for those that have a good reason for not funding on this basis.
What else is new?
The consultation signals a more directive approach to scheme funding from TPR, not out of line with messages in recent years – particularly those on the importance of integrated risk management and long-term planning. There are some new points:
- All schemes must set a long-term objective (LTO), which should reflect low dependency on the sponsor covenant. Trustees should be targeting full funding on the LTO basis by the time their scheme reaches ‘significant maturity’. The definition of terms such as ‘low dependency basis’ and ‘significant maturity’ will be the subject of the second consultation, although TPR has signalled that it expects the LTO to be calculated using a discount rate in the region of gilts plus 0.25%-0.5% per annum.
- Technical provisions, which continue to drive contribution requirements, should be clearly linked to the LTO, with that link strengthening as the scheme matures.
- There will be greater regulatory interaction for those choosing the bespoke route, with a likely requirement to provide robust risk analysis and details of mitigants that have been put in place.
- For the first time, TPR will routinely consider asset allocation, and set limits around the level of investment risk it expects schemes to take at different maturities, to qualify for fast track.
- The support provided by the sponsor covenant will be assumed to reduce over time. The rate of this reduction will depend on the visibility of the sponsor covenant, but TPR expects this to not extend beyond three to five years typically.
Recovery plans
Deficits should be recovered as quickly as affordability allows, and therefore the expectation is that schemes with stronger employers will have shorter recovery plans (perhaps around six years). Any affordability constraints that push out the length of recovery periods will need to be clearly evidenced, and trustees will be expected to have sought mitigants.
Open schemes
To qualify for fast track, schemes open to new benefits may be required to treat accrued liabilities and future accruals separately, so that accrued liabilities have the same level of security in an open scheme as they would in a closed scheme. That said, the fact that open schemes may well be maturing more slowly than closed schemes will allow greater flexibility in investment risk, and provide more time to target reaching their LTO under fast track.
Key areas for consideration
The new Code should focus trustees’ and sponsors’ minds on planning for the longer term, rather than focusing on getting each valuation over the line. It may also reduce running costs over time for those schemes where a fast track approach is feasible. This will be particularly welcome for smaller schemes where the cost of professional advice is high relative to the scheme’s size.
That said, there is an almost inevitable implementation cost associated with transitioning to this new regime, and this will be disproportionately borne by smaller schemes at the outset. Moreover, for schemes that are unable to, or choose not to, follow fast track, the cost of regulatory interaction and analysis may well increase. This transition cost is one of a number of areas that require consideration, including those where unintended consequences may well arise, which might include:
- An increase in the cost of compliance without improving member security
- A ‘levelling down’ of funding strategies (ie more sophisticated approaches being deconstructed simply to ensure alignment with fast track)
- Schemes de-risking and reducing achievable investment returns too quickly, leading to worse long-term outcomes
- Undue pressure on corporate finances, leading to insolvencies
- The closure of otherwise viable open schemes.
The Pensions Board of the IFoA has responded to the consultation, highlighting five key areas where the opportunity exists to mitigate these risks:
- It is important to ensure that the new Code does not lead to the unwinding of sensible and innovative funding strategies that are designed to be in members’ best interests. Therefore, we called for the bespoke framework to be genuinely bespoke and to enable consideration of each case on its own merits. This is particularly relevant for schemes that are open to new entrants, which we think merit a significantly bespoke approach.
- We support the principle that there should be a link between the technical provisions and the LTO, but we do not support any prescription or heavy restriction on the assumptions that may be used to determine either metric. We are strongly in favour of an approach whereby fast-track technical provisions are benchmarked as a proportion of the LTO. The individual assumptions adopted should then be left to each scheme to agree, based on their own specific circumstances. This reduces the ability to ‘game’ the choice of individual assumptions and also moves away from a prescriptive ‘minimum funding requirement’ type regime, with all the drawbacks that would bring.
- We note that ‘investment return’ should not be used as a proxy for ‘investment risk’. It is possible to generate higher or lower investment returns for a given level of risk, so schemes adopting a sensible risk-managed strategy should not be required to reduce the expected return on their portfolio. In many cases, reducing expected investment return could increase the risk of failing to meet members’ benefits. In our response, we have also highlighted areas where investment risk for schemes adopting a cashflow-driven investment strategy could be considered in a different way from that set out in the consultation.
- We encouraged the use of existing reporting infrastructure wherever possible, in order to reduce the regulatory cost associated with implementing the new Code. Where reasonable analysis can be conducted based on information already being provided through the scheme return or elsewhere, we suggested that this is used rather than asking for additional metrics to be provided.
- We point out there may be a need for transitional periods within fast track for those schemes where the existing strategy is out of line with achieving an LTO within the parameters set out in the consultation. This may avoid situations where a scheme falls outside of fast track unnecessarily at its first actuarial valuation following the introduction of the Code.
While our response to the consultation reflected the consensus view of the IFoA Pensions Board, we recognise that it will not capture the individual views of all our members, which may vary considerably depending on their experience and the schemes or sponsoring employers they work with.
We continue to encourage IFoA members working in pensions, and the schemes/employers they represent, to engage directly with the consultation process – in particular considering the impact assessment report and responding to the second consultation.
It is important that as wide a range of viewpoints as possible can be considered by TPR when developing the draft Code. This will make it more likely that the eventual Code will be workable for the majority of DB schemes and that unintended or unforeseen adverse consequences for schemes can be avoided.
Marian Elliott is managing director at Redington and a member of the Pensions Board, Management Board and Council of the IFoA
Mark Williams is principal and London practice leader at Buck, and is Chair of the Pension Board at the IFoA
