A new statutory objective for the Pensions Regulator has just been published. The Government has confirmed that the Regulator will be given a new objective to 'minimise any adverse impact on the sustainable growth of an employer' when carrying out its regulatory functions in relation to scheme funding.
The wording of this new objective is hot off the press but its effects already appear to be present in the second annual funding statement issued by the Regulator.
A reminder of last year's statement
The Regulator's first scheme funding statement was not full of surprises. Not being overly optimistic about investment returns and ensuring that suitable contingency plans were in place would appear to capture the spirit of that statement.
Trustees seeking to increase asset outperformance assumed in the discount rate were expected to understand the additional risk involved. The first statement also urged trustees to accommodate strongly held views about future financial market conditions in the recovery plan rather than in the technical provisions, in which case 'viable contingency plans...suitably documented' were also expected.
Where recovery plans became the subject of material extensions, the Regulator expected 'sound justification' for those extensions. Where cash was being used at the expense of pension contributions the Regulator expected it to be used to improve the employer's covenant.
Has a great deal changed under the second statement?
The second statement is making a number of points which are not exactly new but the tone is altogether more conciliatory than the previous statement.
A key part of the first statement was the Regulator's belief that there was sufficient flexibility within the existing funding framework to address the challenges faced by schemes in the current climate. That has not changed. The latest statement does emphasise, however, that trustees should feel that they can make use of those flexibilities.
The key messages coming out of the second statement are as follows:
An integrated approach
The Regulator wants trustees to take an integrated approach to addressing covenant, investment, and funding risks and to be able to show how this has been done. The Regulator envisages this approach will enable trustees 'to incorporate the ability of employers to support the scheme in their overall risk management approach and allow for an appropriate level of risk to be taken that is neither overly prudent nor overly optimistic'.
More on integrated risk management is promised in the Regulator's consultation later this year (see below).The Regulator says that a key area of focus when it engages with schemes will be the link between the strength of the covenant, the scheme's investment strategy, and the prudence in the discount rates compared to expected investment returns. As trailed in other pronouncements by the Regulator during the last year or so, the Regulator continues to move away from triggers and towards a suite of risk indicators, in line with integrated risk management.
Use the flexibilities already there
The Regulator acknowledges that trustees may need to make greater use of the flexibilities available than needed for their preceding valuations. The flexibilities relate to setting the discount rates for technical provisions and the investment return assumptions for recovery plans.
The Regulator indicates that it would be happy for trustees 'to adopt an approach that best suits the individual characteristics of their scheme and employer'. The Regulator also says that the choice of investment return in the recovery plan does not necessarily have to be the same as the technical provisions discount rate, but 'it is important that it is consistent with the overall risk management of the scheme'. It expects Trustees to seek an open dialogue with the employer and agree how to use the flexibilities within the funding framework 'to most appropriately fit their individual circumstances' while understanding the risks and putting 'appropriate plans for mitigation' in place.
This appears to be a clear recognition of the challenges faced by DB schemes. The tone of the statement seems to be more one of encouragement than that of last year's statement. The emphasis is on bespoke arrangements that would suit the scheme and employer in question would appear to be a logical approach for the Regulator to take in view of the move away from triggers.
In setting contribution levels trustees should take into account what is reasonably affordable for the employer. As a starting point, trustees should consider whether the current level of contributions can be maintained. Where there are 'significant affordability issues' trustees may need to consider whether it is appropriate to agree lower contributions and possibly a longer recovery plan. Trustees should document the reasons for any change and indicate that they have considered the risks.
What might be 'significant affordability issues' for one scheme employer might not be for another. It will be interesting to see how the Regulator's new objective will fit in alongside the affordability aspects of its funding statements, Code and defined benefit regulation document.
Focus on the employer covenant
Where there is tension between the need for scheme contributions and for investment in the employer's business, the Regulator says that it is important that the solution found neither damages the employer's covenant nor benefits other stakeholders at the expense of the scheme. If investment in the business is being prioritised at the expense of what otherwise would have been affordable contributions, the Regulator wants it to be used to improve the employer's covenant.
The Regulator's suite of risk indicators includes any specific issues and concerns relating to a deterioration in the sponsor's covenant strength. Strengthening the employer covenant continues to be a key focus for the Regulator (this point was made in last year's statement).
In a conference speech last autumn, the Regulator warned trustees against 'reckless prudence', both in the context of employer contributions and investment strategy: 'There will be occasions when the right thing to do for the employer and the scheme will be to invest in the growth of the sponsoring company rather than making higher pension contributions.'
Keep a record
Trustees should document their reasons for any changes in their investment return assumptions and consider any increase in risk this might bring. They must also do this in relation to affordability.
It has always been important for trustees to be able to provide a paper trail for any decisions that they take. This is in essence a reminder of good governance.
What can we expect to see in the coming months?
The Regulator is planning to consult on revisions to its scheme funding Code of Practice as well as its approach to regulating DB schemes (a regulatory strategy is scheduled for publication 'early in 2014').
Where does this leave trustees?
This latest statement by the Regulator appears to signal an increased desire to engage with trustees and employers facing the difficulties of the current economic climate.
As ever, trustees are expected to walk a tightrope. Being neither overly prudent nor overly optimistic is a difficult trick to pull off. The message that trustees are perhaps being encouraged to take away is that if they look at the bigger picture and take a careful look at the risks, and can show that they have done so, then they are less likely to fall off that tightrope. The Regulator is urging trustees to 'seek an open dialogue with the employer' - this will be easier for some trustee Boards than for others.
The Regulator's new statutory objective will also form a very important backdrop for schemes and their advisers, as will the revisions to the Code of Practice on funding and the Regulator's approach to defined benefit regulation, once the consultations and changes are issued later this year/early next year.