The Pensions Regulator (TPR) is proposing changes to its approach to defined benefit (DB) scheme funding, taking into account TPR’s new statutory objective of minimising any adverse impact on sponsoring employers’ sustainable growth. This briefing will be of interest to all employers providing defined benefits. The updated Code of Practice is expected to come into force in July 2014, when it will replace the existing Code of Practice 3: Funding defined benefits, published in 2006.
Introduction: the new framework
On 2 December 2013, TPR launched a consultation on its proposed changes to the future regulation of DB pension schemes. The extensive consultation documents include:
- a detailed policy document which sets out how TPR will assess scheme risk and how it will target its future interventions. This document is intended to replace TPR’s statement published in 2006 “How the Pensions Regulator will regulate the funding of defined benefits”; and
- a revised draft Code of Practice, “Funding defined benefits”, which provides practical advice and which is intended to replace the existing code of the same name published in 2006 (the 2006 Code).
In essence, TPR is proposing a new principles-based regime which it intends will be flexible rather than prescriptive, as well as outcome-focused. In assessing the combined scheme risks of covenant, investment and funding, TPR sets out a new key risk indicator, the “Balanced Funding Outcome” (BFO). The draft Code sets out the principles trustees should follow in their approach to scheme funding and cites, as a key focus, the adoption of an integrated approach to risk management.
Reasons for the review of the 2006 Code
TPR’s regulatory approach to DB scheme funding is underpinned by its statutory objectives, the main ones being to:
- protect the members’ benefits under occupational pension schemes;
- reduce the risk of compensation being payable from the Pension Protection Fund; and
- promote the good administration of work-based pension schemes.
The principal reason (described by TPR as its “primary driver”) for the consultation is to take account of its new statutory objective in the Pensions Bill 2013:
“[as regards the exercise of its functions in relation to scheme funding] only, to minimise any adverse impact on the sustainable growth of an employer”.
The exact wording of the new objective has yet to be finalised, but the consultation assumes that the objective will be framed as above. TPR stresses that it does not prioritise one statutory objective over another. Specific objectives and operational plans will be published annually in TPR’s funding statement. The statement for this year is due to be published in “Spring 2014”.
The other reasons TPR gives for the review are to reflect its developing approach after eight years of regulating DB funding and to take into account the significant shifts in the DB landscape, such as scheme closures and scheme maturity.
The revised Code is expected to come into force in July 2014, but trustees and employers completing scheme valuations between now and then are urged to bear it in mind.
TPR’s approach and some new concepts
In focusing on the principal theme of an integrated approach to risk management, TPR’s strategy will be deployed in three key ways.
Firstly, by emphasising collaboration between trustees and the employer. TPR recognises the commonality of interest between the parties and will encourage an ongoing dialogue between them in order to reach the funding objective. There is no presumption of a trustee-employer conflict, and TPR expects trustees to manage funding, investment and employer covenant risks on an integrated basis through collaborative interaction with the employer. The employer covenant is expected to be the “cornerstone of the trustees’ approach”. TPR expects trustees to take an integrated approach to risk management when developing a scheme funding solution, bearing in mind the aforementioned three broad risk areas of covenant, investment and funding, none of which should be considered in isolation.
Secondly, the new statutory objective is encapsulated by the promotion of balance. In its key principles, the draft Code states that “trustees must discharge their duties, and act in the interests of their members but in doing so they will need to consider the needs of the employer supporting the scheme”. It goes on to state that trustees should ensure that their decisions do not “compromise the needs of the scheme; unreasonably impact on the employer’s sustainable growth plans and its long term ability to support the scheme; or involve taking excessive or unnecessary risks.”
Thirdly, TPR also details how it proposes to assess risk and identify schemes where it may intervene. TPR intends to be less prescriptive and not to focus on single issues. In targeting its interventions, the old triggers which focused on specific aspects of technical provisions and recovery plans have disappeared. The intention is to intervene in fewer cases, “about 200 per year” with a “quality not quantity” approach. TPR hopes to concentrate on fewer schemes but in more depth and to target its resources on schemes where it feels it can make a difference – that is, on larger schemes where risk to TPR’s objectives is greater.
The Balance Funding Outcome (BFO)
The more rigid “triggers” which heralded TPR scheme investigation or intervention in the past have been replaced by a suite of risk indicators. The primary new risk indicator is the BFO, which, broadly, will represent a benchmark level of deficit contributions taking into account covenant strength and scheme maturity. The actual agreed level of deficit contributions will then be measured against this benchmark. There will be no set a minimum level of funding or contributions, but TPR will assess the level of risk associated with a particular scheme by looking at the covenant strength and the scheme’s funding needs.
However, the BFO will not take into account constraints on affordability. Therefore, TPR recognises that for some schemes and employers, the appropriate balance in a scheme may be different from that initially indicated by the BFO. TPR expects trustees to work with the employer so that they understand the employer’s business plans and the employer’s ability to underwrite the risks to the scheme. Once trustees have identified and assessed the risks, they will be able (TPR says) to set their investment and funding strategies consistently with an acceptable level of scheme risk.
TPR does not expect all risk to be eliminated. It does, though, expect trustees to understand the risks and to be comfortable with them. Trustees should understand how “sustainable growth” applies to their employer, and any accepted risk should be supported by the employer covenant, unless the trustees are satisfied that any risk to members is justifiable or otherwise mitigated.
The BFO will be used by TPR as its primary factor in assessing risk. Other factors include investment strategy, mortality and back-end loading of contributions under a recovery plan. The greater the shortfall in a scheme compared to its notional BFO, the more likely it is that the scheme will be further investigated by TPR. In making decisions on where to target its interventions, TPR sets the “risk bar” according to the strength of the scheme’s covenant. For this purpose, TPR will grade scheme covenants into four segments: “strong”; “tending to strong”; “tending to weak”; and “weak”.
Assessing covenant strength
TPR recognises scheme covenant evaluation as a key part of its risk assessment process. It allows TPR to look for specific events or circumstances, such as the avoidance of scheme liabilities, which put schemes at risk. TPR also recognises that there is “no one size fits all” solution. Its main measurements will include such factors as business outlook and plans for sustainable growth, strategic outlook for the sector and position of the employer within the industry, trends in the employer’s profitability over time, level of debt and the strength of the company’s balance sheet. The benchmark BFO for each of the four covenant segments set out above will be regularly reviewed, with detail being provided annually in TPR’s funding statement.
TPR proposes to hold follow-up meetings with stakeholders and it encourages trustees and employers to attend future seminars on the proposed new approach. The consultation closed on 7 February 2014, and TPR’s aim is to publish the consultation response and to lay the revised Code in early May 2014. The new Code would then be effective from July 2014.
Trustees and employers should ensure they are familiar with the new concept of a scheme BFO as soon as possible, as TPR urges them to bear the new Code in mind during the pre-implementation period. Those with schemes about to start a valuation will need to monitor developments over the coming months.
The consultation and its extensive support documents (running to some 150 pages) have been met with mixed industry reaction.
In our view, it is unsurprising that TPR’s future approach to scheme funding is flexible and more employer-friendly, given that the new statutory objective is to minimise any adverse impact on the sustainable growth of the sponsoring company. However, the new BFO objective benchmark allows room to manoeuvre within scheme funding plans.
The key message to be taken from the revised Code is that TPR expects trustees to adopt an integrated approach to risk management. Trustees have long been aware that it is essential they understand events and circumstances which may impact on the employer covenant, and this has not changed. The better the communication between trustees and the employer, the more likely trustees will be able to obtain the information they need to assess any risks to their scheme, negotiate scheme funding accordingly, and stay beneath TPR’s intervention radar.
Nevertheless, the new material is extensive, and to an extent repetitive, although differing in the level of detail provided. The fact that TPR is advising trustees to have regard to it in current valuations perhaps suggests that TPR will not permit material change to it in the consultation. Trustees may wish to tackle the draft documentation by first absorbing the approach set out in the appendices to the policy document dealing with the new concepts of the BFO and covenant grading, then look subsequently at the new draft Code, which offers guidance on the funding principles universally applicable to DB schemes.