The Pensions Regulator published the revised version of its new code of practice on funding defined benefits on 10 June. It is expected to come into force over the next few months following extensive consultation on the earlier version published in November 2013. It will replace the existing code on funding defined benefits which was put in place in 2006. As well as the code, the Regulator has published its annual defined benefit funding statement, its defined benefit funding strategy, its defined benefit funding policy and an essential guide to the DB code.
The code reflects the Regulator's new statutory objective to "minimise any adverse impact on the sustainable growth of an employer". The key message is that a strong, ongoing employer alongside an appropriate funding plan is the best support for a well-governed scheme. The code emphasises that balance between the needs of the employer with those of the scheme is essential to allow employers to invest in the growth of their business. The trustees and the employers should work openly and in a transparent way to ensure the best result is reached for all parties.
With this message in mind, the code highlights nine "principles" which trustees and employers should bear in mind when funding the scheme. These include working collaboratively, managing risk, taking risk, adopting a long-term view, acting proportionately, seeking balance, good governance, treating the scheme fairly and reaching funding targets.
Three of the fundamental concepts underlying the code and funding documents are summarised below:
- Assessing and managing risk
The code acknowledges that it is not necessary to eradicate all risks, especially where the risk presents potential rewards. However, it stresses that risks must be understood and managed appropriately. The trustees should adopt an integrated approach to risk management which means understanding employer covenant related risk, investment related risk and funding related risk, and how each element of risk impacts on the other rather than in isolation. One important aspect of risk management is contingency planning. The code says that trustee risk management plans should identify the potential steps they may take to preserve a balanced funding strategy when risks crystallise.
- Employer covenant considerations
The code emphasises the importance of understanding the impact of the employer covenant on the scheme. This means looking at the covenant now and how it could grow and develop in the future. Although it says the review of the covenant should be proportionate, the code suggests that trustees should undertake an in-depth review unless there has been no material change since the covenant was last assessed or the scheme is very small in comparison with a strong employer. Areas which the trustees should consider include the employer's position within the group, its trading and balance sheet position, its forecast profit and cash generation, an estimate of the value that might flow to the scheme on insolvency of the employer and the nature of the employer's industry.
One of the more challenging concepts of the code is that trustees should recognise that employers often need to invest in their businesses to enable them to grow and/or fulfil their obligations which should, in turn, help the trustees achieve their key funding objective. The challenge for trustees is to understand the employer's plans in order to assess, for example, how an employer's proposal to prioritise the investment it wishes to make in its business over making funding available to the scheme will impact on the covenant and funding risks. The code suggests that in some instances the servicing of other debts and raising additional equity may contribute significantly to business success and be in the long-term interests of the scheme.
- Intervention by the Regulator
The Regulator's funding policy contains the factors it will take into consideration when deciding on whether to engage further with schemes. These factors include the position of the scheme compared to the Regulator's "risk indicators", the size of the scheme’s liabilities, the potential complexity and resource intensity of the Regulator's engagement compared to the impact and the value it can add through further engagement and the overall resources it has available.
It also divides employers into four broad categories from strong to weak according to how well they are able to support the scheme as a means of prioritising its resources.
The list of risk indicators is long and includes, for example, a covenant assessment, any investment strategy risk, mortality, governance and the "funding risk indicator". There is little information on the funding risk indicator other than it will involve assessing the "appropriateness" of the proposed contribution rates by reference to the scheme's maturity, the strength of covenant and the level of assets relative to a standardised liability measure.
The revised version of the code is centred around the Regulator's new objective to minimise any adverse impact on the sustainable growth of an employer. Trustees can accept a degree of risk provided it is managed and recovery plans should be eliminated over "an appropriate period" rather than "as quickly as the employer can reasonably afford". This change in emphasis will certainly help employers when negotiating funding arrangements with trustees going forward.
In some instances, the Regulator's new objective may not sit easily with its other objectives to protect members' benefits and reduce calls on the Pension Protection Fund. Whilst a strong employer is clearly good news for its pension scheme, in practice striking a balance between the needs of the employer and those of the scheme may be difficult. However, unfortunately, there is little practical guidance for trustees within the code.
The revised version of the code is an improvement on the earlier version published at the end of 2013. It is shorter and some of the more confusing terminology has been removed. For example, rather than requiring trustees to "mitigate" risk, references have been changed to "managing" risk. The section on contingency planning has also been amended to make it more realistic and proportionate.
The sheer volume of reading across the code and the funding documents is daunting (even taking into account that the finalised code is 20 pages shorter than the first version). It will inevitably take trustees, employees and their advisers time to get to grips with what it all means, especially as many of the differences between the new code and the existing one are subtle and represent more of a shift in emphasis than stark changes.