Introduction

The Pensions Regulator (TPR) has issued a new scheme funding code (the Code) for defined benefit (DB) schemes, which came into effect on 29 July 2014. This replaces the scheme funding code which has been in place since 2006 (the 2006 Code), and was updated primarily as a result of the new statutory funding objective for TPR in exercising its functions:

“to minimise any adverse impact on the sustainable growth of an employer”.

TPR has stated that the same weight will be given to this new objective as its other objectives, including the protection of scheme members and protecting the risk of calls on the Pension Protection Fund (PPF). It remains to be seen whether this will be a delicate balance for TPR.

Nevertheless, the Code makes significant changes to previous practice, so it will be of interest to all DB scheme trustees and employers.

TPR’s aim

As mentioned above, the primary aim of TPR in the Code is to reflect its new objective, but it is clear from the documents comprising the Code that TPR also wishes to promote balance between employers and trustees, and to reflect its experience of regulating DB schemes since the 2006 Code came into force, and changes which have taken place over that period (for example, scheme closures and increases in maturity). TPR clearly wishes to ensure that its framework remains fit for purpose, and stresses the requirement for appropriate intervention:

“in particular the Code recognises that a strong, ongoing employer alongside an appropriate funding plan is the best support for a well governed scheme”.

Documents comprising the Code

At first blush, there is a confusing array of documents:

  • the consultation response;
  • an essential guide to the DB code (which is an overview of the Code for trustees);
  • Funding Defined Benefits Code of Practice No.3 (which guides trustees on the scheme funding approach);
  • DB Regulatory Strategy (which sets out TPR’s strategic objectives);
  • DB Funding Regulatory and Enforcement Policy (which outlines TPR’s approach to regulation); and
  • 2014 annual DB funding survey.

Whilst the documentation is generally well written, and considerably shorter than the versions issued for consultation, there remains a risk of inconsistency due to its voluminous and slightly repetitious nature.

What is the status of a code?

The Code is intended to offer practical guidance to trustees. Codes issued by TPR are not statements of the law, and it is not mandatory for them to be followed. However, the legislation provides that when determining whether legal requirements have been met, a court will take the relevant provisions of a code into account in the event of litigation (which will include matters before the Pensions Ombudsman and the PPF).

The Code applies to all DB schemes with valuation dates after 29 July 2014. Tranche 9 schemes (that is, schemes with valuation dates between September 2013 and September 2014) should take the Code into account:

“as far as is reasonable”.

Balancing risks

TPR intends the new regime to be more flexible, and in particular it will look at the three main pension risks together, namely the covenant of the employer, investment risk and funding risk. The rationale of the interaction is that a material change to one risk will affect the other two. TPR does not, however, think it is necessary to eradicate risks completely but:

“risks should be understood and managed appropriately”.

The key funding principles in the Code

The Code sets out nine key funding principles for DB schemes, as follows;

  • working collaboratively;
  • managing risks;
  • taking risks;
  • taking a long term view;
  • proportionality;
  • balance;
  • good governance;
  • fair treatment of the scheme by the employer; and
  • reaching funding targets.

Proportionality and balance are two terms which permeate the Code, which stresses that trustees should act proportionately based on the size of their scheme, the complexity of its provisions and its risk tolerance. Trustees should balance the need to pay the promised benefits whilst minimising the adverse effect on the employer’s sustainable growth.

Key themes from the funding and enforcement policies

It is clear that TPR’s focus in these documents is an emphasis on collaboration between trustees and employers, to achieve the appropriate funding outcome. There should be an integrated approach to risk management, stressing the importance of the employer covenant. However, it is clear that sustainable growth will mean different things to different employers:

“for some growth is a real prospect whilst for others it may be more about maintaining their position or slowing a business decline”.

Leading themes from regulatory strategy paper

It is clear that TPR envisages that there will be less prescriptive intervention. The triggers which previously tripped regulatory intervention (for example, the length of a recovery period) are removed and TPR will instead look at risk indicators, namely covenant strength, funding, investment risk and governance. It is clear that this is something of a work in progress, and different risks may be set for different scheme segments (for example, based on employer size). This is strongly linked to TPR’s new approach to covenant, which TPR stresses is a key aspect and enables trustees to decide on the appropriate level of risks. TPR will assess schemes on the basis of four different covenant segments, namely strong, tending to strong, tending to weak and weak. This is a significant change to TPR strategy, and it remains to be seen what the outcome will be in practice.

The table at page 11 of TPR’s DB funding and regulatory enforcement policy indicates the approach to covenant very clearly.

Funding and valuations

TPR stresses that assumptions should be prudent and evidence based, and technical provisions should not be compromised to make a recovery plan appear affordable. Under the 2006 Code, a deficit was to be eliminated as soon as the employer could reasonably afford. The Code states that a deficit should be eliminated over an appropriate period. While TPR states that this is not a change in regulatory policy, it may in practice prove to be so, as many trustees understandably interpreted reasonable affordability as being a requirement to eliminate a deficit as quickly as possible.

Each valuation will be tested against TPR’s risk indicators, and that will determine whether there is a need for further action. Again, TPR stresses proportionality.

The 2014 annual DB funding statement

TPR uses annual funding statements to communicate messages to schemes between valuation. The 2014 annual funding statement is primarily aimed at tranche 9 schemes and it sets out TPR’s view of market conditions. TPR states that it expects trustees to evidence an integrated approach to risk management, a proportionate approach to governance, and the employer’s ability to address adverse outcomes.

How do the Codes compare?

The main differences are set out below:

Click here to view table.

Conclusion

In the view of Norton Rose Fulbright, the new Code is an improvement on the 2006 Code, and should result in a fairer balance in negotiations between employers and trustees. However, there are some obvious pros and cons to the new Code, as set out below, and it remains to be seen how it will be interpreted by TPR staff.

Click here to view table.