On the 29 July 2014 the Pension Regulator's ("The Regulator's") revised Code of Practice No. 3 on funding defined benefits (the "DB Code") came into force, and is designed to provide guidance to trustees and employers to assist them in complying with the scheme funding requirements under Part 3 of the Pensions Act 2004, replacing the earlier existing version of the code of practice of February 2006.
The DB Code was previously published in draft form alongside a draft DB regulatory strategy and a draft DB funding policy. These documents were published by the Regulator as part of a consultation on 2 December 2013, the "key driver" for the Regulator's proposed new approach to DB regulation being the fact that (pursuant to section 48 Pensions Act 2014) from 14 July 2014 it has been subject to a new statutory objective to minimise any adverse impact on the sustainable growth of an employer when undertaking its funding functions.
In its consultation response, the Regulator explained that it received responses to the consultation from a wide range of stakeholders (including representative and professional bodies, employers, trustees, advisers and individuals). The Regulator further explained that the responses were broadly supportive of the Regulator's proposed approach to its statutory objective, the consultation code and the DB regulatory framework.
Despite the broad support noted in the the Regulator consultation response for its overall proposed approach, the Regulator has made a number of changes to the final version of the DB Code from the draft version published last year, partly as a result of certain concerns raised during the consultation process.
One area of change has been with regards to the Regulator's new statutory objective on sustainable growth. The consultation response noted some respondents had felt that the new statutory objective had been "underplayed" in the draft DB Code because the exact wording of the objective, namely "minimising any adverse impact on the sustainable growth of an employer" had not been used, thereby undermining the policy intention behind the objective. Given this, the final DB Code now incorporates the specific wording of the objective.
With regards to risk-management, a concern was raised during the consultation that the original drafting may have been interpreted as meaning all risks that may crystallise need to be covered. The Regulator, in its consultation response notes this was not its intention, and as a result the final DB Code has been re-drafted to replace references to "mitigating risks" with "managing risk" to make clear that an employer should neither have to cover all conceivable risks, nor repair immediately those which crystallise.
In addition, some respondents to the consultation had felt the principle within the draft DB Code that "trustees should aim for any funding shortfall to be eliminated as quickly as the employer can reasonably afford" to mean that recovery plans should be as short as possible. Given this, in the final DB Code, the Regulator has changed the emphasis on reasonable affordability away from paying deficits as quickly as reasonably affordable to considering the appropriate period in which to do so in view of the risks to the scheme and the impact on the employer.
The Regulator has also modified the final DB Code to acknowledge that it may be appropriate for schemes with strong technical provisions to have longer recovery plans. Nevertheless, in its consultation response, the Regulator emphasised that equally those schemes (even those with strong covenants) that set weak technical provisions in line with the risk-taking capacity of their covenant, should not increase risk by operating a long recovery plan.
Another area of the DB Code which has been changed from its draft code relates to the requirements regarding contingency planning. A number of respondents to the consultation felt the draft DB Code required there to be documented mitigations for every conceivable adverse event, which the Regulator acknowledged was unrealistic. Given this, the final DB Code has been redrafted to ensure the emphasis is on trustees considering the likely adverse outcomes and what they may do in those circumstances and ensuring they have adequate and flexible strategy and governance structure to address these outcomes. In its simplest form, this could involve the identification of triggers for provision of information and review and discussion by both trustees and the employer of how matters might be addressed.
The section of the DB Code on dividend payments has also been redrafted to underline that the payment of dividends by an employer is a normal business activity which can be consistent with both the employer's sustainable growth plans and the trustees' funding objectives to pay benefits as they fall due. The DB Code further provides that the need to scrutinise the employer's dividend policy depends on the circumstances and should be proportionate. It goes on to explain that trustee scrutiny can be limited to those situations where the covenant strength is a concern, where the timing of the proposed dividends is unusual or where exceptionally large dividends are proposed.
The final DB Code has also been redrafted following some concerns raised during the consultation that the draft DB Code appeared to elevate the pension scheme above other creditors, giving trustees too much say over the employer's investment and other key business decisions. The final DB Code now makes 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 the trustees' scrutiny.
DB Funding Policy
Significant changes have also been made to the draft DB Funding Policy. The draft DB Funding Policy included a number of "risk indicators" which were designed to help the Regulator target its interventions, the primary risk indictor being whether and by how much schemes fall short of the "balanced funding outcome" (BFO) indicator. The consultation response noted that while many respondents welcomed the moved away from the previous triggers to using a broad range of risk indicators, there were concerns about the Regulator's proposal to publish the BFO (subsequently renamed in the final DB Funding Policy as the Funding Risk Indicator (FRI)). In particular, concerns were raised that the BFO/FRI could be perceived as a new funding requirement, distracting trustees from focusing on the important issues and potentially creating a levelling down of scheme funding. Given this, the Regulator has decided, for the time being, not to publish the level of the risk indicators (beyond a high-level description).
It is likely that the changes introduced by the Regulator following the responses received to its December consultation will be welcomed, in particular the clarification in the final DB Code of the Regulator's new statutory objective, the exact statutory wording of which now appears throughout the DB Code. In addition many previous concerns will have been allayed by the shift in focus away from eliminating any funding shortfall as soon as possible and instead considering the appropriate period in which to do so in view of the risks to the scheme and the impact on the employer, something that should be welcomed by trustees and employers alike.