Background

In our February 2014 e-bulletin we reported on the Pension Regulator's ("TPR") efforts to introduce a new code of practice and regulatory approach to funding defined benefit (DB) schemes. The current code of practice dates back to February 2006. TPR published a draft (for consultation) code of practice no.3 on funding defined benefits schemes in December 2013. The 10 week consultation period ended in early February 2014, and just over four months later, on 10 June 2014 TPR published the revised code (the "DB Code").

We understand that the DB Code will (hopefully!) take effect from 22 July 2014 and it will reflect: (i) the evolution of DB scheme funding over the last eight years; and (ii) TPR's new statutory objective "to minimise any impact on the sustainable growth of an employer"[1]

The main changes to the DB Code following consultation

The vast majority of the 85 responses to the consultation process were supportive of TPR's approach. The DB Code remains broadly the same as in the consultation draft but the new version has some important changes particularly on TPR's approach to its new statutory objective – some might say that the new code represents a softening of TPR's initial approach. The code is also 20 pages shorter, which is good news for everyone (especially pension lawyers!).

The main changes to the DB Code since it was published in December 2013 include: 

  • Interpretation of the new objective on sustainable growth – some respondents believed that the consultation code did not fully reflect TPR's new statutory objective. The DB Code now uses the precise wording of the objective from the Pensions Act 2014;  
  • De-risking – many respondents felt that the consultation code placed too much emphasis on downside risk and could be interpreted as suggesting that schemes should de-risk, therefore placing undue stress on the employer. TPR amended references to 'mitigating risks' to 'managing risks', and that the employer should neither have to cover all conceivable risks, nor repair immediately those that crystallise;  
  • Recovery plans – TPR has considered concerns that the principle in the consultation code that 'trustees should aim for any funding shortfall to be eliminated as quickly as the employer can reasonably afford' may have been interpreted to mean that recovery plans should be as short as possible. To counter this, TPR has changed the emphasis on reasonable affordability away from repaying deficits as quickly as possible to require deficits to be eliminated over an 'appropriate period'; 
  • Contingency planning– the emphasis is now on trustees thinking about the likely adverse outcomes and what they may do in those circumstances. Schemes should have adequate and flexible response strategies and governance structures to allow trustees to respond as and when risks develop. At its simplest, this could involve identifying triggers for review and discussion between trustees and the employer;  
  • Covenant assessment and the reliance on the long term – TPR has recognised that it may not be feasible to formally assess covenant in the long term by using forecasts and stressed the importance of looking at a range of plausible scenarios to assess the likely strength of the covenant beyond the medium term. The need for ongoing monitoring of the covenant was highlighted;  
  • Dividends – the DB Code has been redrafted to address concerns about the payment of dividends and the fact that these are a normal business activity which can be consistent with employer's growth plans. Trustee scrutiny of the employer's dividend policy should only really come into play when, for instance, the covenant is constrained, dividend payments take place at an unusual time or are exceptionally large. TPR has removed the phrase 'in line with industry norms' as it is not something trustees should be expected to assess;  
  • Running a business – some respondents expressed concern that the consultation code seemed to elevate the pension scheme above other creditors, giving trustees too much say over the employer's investment and other key business decisions. Changes have been made to the DB Code to make it clear that it is not for trustees to be involved in, or criticise, the key business decisions made by employers and that in most cases employers should be free from trustees' scrutiny. The circumstances in which scrutiny will be necessary have been clarified – for example, where employers are asking for investment in the business to be prioritised over contributions that the scheme needs, trustees need to understand the nature of the investment plans and likely impact on covenant; and  
  • Transparency around risk indicators – at the moment TPR has decided not to publish detail on where it sets its risk indicators. TPR believes that there are significant benefits to be gained in using the Funding Risk Indicator (previously named the Balanced Funding Objective) and will be publishing more on this and all risk indicators over the next year. 

The key funding principles (still nine of them) 

Our February 2014 e-bulletin sets out TPR's key funding principles. These remain in the DB Code but now take account of the changes noted above. These can be summarised as follows: 

  • trustees and employers should work collaboratively in an open and transparent manner that recognises the employer's "sustainable growth";  
  • an integrated approach to risk management and setting triggers for action which seeks to monitor the "holy trinity" that is employer covenant, investment and funding risks;
  • confidence that the employer covenant is strong enough for risks to be managed over an appropriate period;  
  • trustee decisions should be consistent with the long term views of the employer strength; 
  • the trustees should act proportionately in carrying out their functions given their scheme's size, complexity and circumstances;  
  • trustees should not compromise the needs of the scheme, unreasonably impact on the employer's sustainable growth or take excessive and unnecessary risks;  
  • trustees should adopt good governance standards;  
  • trustees should seek to ensure that the scheme is treated fairly, in a manner consistent with its equivalent creditor status; and
  • having agreed an appropriate funding target, trustees should aim to eliminate any deficit over an appropriate period. 

Action stations… 

Once the new DB Code comes into force it will apply to future valuation dates however, TPR has expressly encouraged trustees to take the DB Code into account for valuations which are currently underway. The general feeling is that the DB Code conveys a positive message and that moving towards a more integrated approach to scheme funding will be beneficial to both trustees and employers. 

"The proof of the pudding is in the eating" and no doubt, trustees, employers and TPR will face challenges in interpreting and policing such a flexible approach to funding. In the meantime, trustees who are currently in the midst of a valuation or just about to embark upon such a process, should consider how the DB Code impacts them and the approach they should be taking. It's also fair to say that familiarity with the DB Code and its principles will also become an essential part of a scheme's day to day operations and will form a necessary component of investment and funding strategy as well as covenant review. 

Employers would also be well advised to become familiar with the DB Code – especially in light of TPR's new sustainable growth objective and to ensure corporate plans for funding and risk fit within the DB Code's framework.