The revised code of practice no.3 on funding defined benefits schemes (DB Code) has been published by the Pensions Regulator (tPR), in conjunction with its regulatory and enforcement policy and strategy. This DB Code replaces the code of practice, which was first published in 2006, and takes into account the responses to the draft DB Code, having been published for consultation in December 2013. The DB Code will come into force within the next few months, once it has received Parliamentary approval, reflecting tPR’s new sustainable growth objective and the position in relation to scheme funding since 2006.
The purpose of the DB Code
The DB Code is intended to provide trustees and employers with guidance on complying with the statutory scheme funding requirements and takes into account tPR’s new statutory objective (from 14 July 2014) to ‘minimise any adverse impact on the sustainable growth of an employer’. The DB Code sets out nine key funding principles which apply to all schemes and there is an emphasis on employers and trustees working together in a ‘collaborative and transparent way’.
Changes to the DB Code following consultation
The 85 responses to the consultation were largely in favour of tPR’s approach and especially the inclusion of the new sustainable growth objective, together with the interplay between this and tPR’s existing statutory objectives. The move to a principles-based approach and the use of an outcome-focused use of risk indicators, rather than the existing triggers system, was also favoured. In general, the DB Code reflects a softening in approach to that proposed in December 2013, with an increased focus on the position of the employer in light of tPR’s new statutory objective.
TPR’s key message is that a strong and reliable employer, together with an appropriate funding plan is the best way of ensuring an effective and well governed scheme. It is important that employers and trustees work openly and in unison to reach an appropriate scheme funding outcome.
The main changes to the DB Code since it was published in draft form include:
- Recovery period: tPR has taken into account concerns that the principle in the draft DB Code that ‘trustees should aim for any funding shortfall to be eliminated as quickly as the employer can reasonably afford’ may have led to an interpretation that recovery plans should be as short as possible. The timescale is now stated to require the deficit to be eliminated over an ‘appropriate period’. This means that schemes with strong technical provisions may have longer recovery plans, however, those that have set weak technical provisions, even if they have a strong covenant, should not add further risk by having a long recovery plan.
- Sustainable growth objective: some respondents believed that the draft DB Code did not fully reflect tPR’s new statutory objective to minimise any adverse impact on the sustainable growth of an employer when exercising its scheme funding functions, therefore the DB Code now uses the exact wording from the Pensions Act 2014. Supplementary guidance will also be published in due course to make clear how the objective should be interpreted by not-for-profit employers or those in the charity sector.
- Managing risks: to reflect that the employer does not need to cover all potential risks or rectify them as soon as they come to fruition, tPR has amended references to ‘mitigating risks’ to ‘managing risks’.
- Contingency planning: the DB Code now requires trustees to have adequate and flexible response strategies and governance structures to allow them to respond as and when risks develop.
- Dividends: the DB Code is now more reflective of normal business practice and an understanding that dividend payments may not be out of the ordinary and may still be made whilst a company is growing and trustees’ objectives to pay benefits in full are being met. Such payments should only be scrutinised where dividend payments are particularly large, are not in line with the company’s normal financial calendar or where the covenant strength is questionable.
- Business decisions: the DB Code reflects that most key business decisions should be made without the involvement of the trustees’ scrutiny and sets out circumstances which may require scrutiny and includes the situation where an employer is asking for investment in the company to be elevated above contributions.
- DB funding policy: tPR resolved not to publish, in detail, where it sets its risk indicators. This was due to the potential for the publishing of the Funding Risk Indicator (formerly the Balanced Funding Objective) to be interpreted as a new funding requirement. TPR will develop a comprehensive approach to risk assessment, including risk indicators, over the next year. The other risk indicators include tPR’s bespoke covenant assessment; investment strategy risk; prudence in setting mortality assumptions; the composition of the previous recovery plan; and poor governance.
The nine key funding principles
The nine key funding principles proposed in tPR’s draft code are still included within the DB Code, however, they have been amended in the ways set out above to reflect the softening approach…
- Working collaboratively: trustees and employers must work together in an open and transparent manner to reach funding solutions that recognise the needs of the scheme and the employer’s plans for sustainable growth.
- Managing risk: trustees should implement an approach which integrates the management of the employer covenant, investment and funding risks; and monitor and address those risks effectively.
- Taking risk: trustees should establish the employer’s risk tolerance and assess the employer’s ability to address a range of likely adverse outcomes over an appropriate period before they take funding or investment risk.
- Taking a long-term view: trustees must act consistently with their long-term funding and investment targets and their view of the employer covenant.
- Proportionality: the trustees functions should be exercised in a manner which takes into account the scheme’s size, complexity and level of risk.
- Balance: the funding outcome should reflect a balance between the need to pay promised benefits and to minimise any adverse impact on the employer’s sustainable growth.
- Well governed: the trustees should adopt good standards of governance.
- Fair treatment: the scheme should be treated fairly amongst the competing demands on the employer, taking into account its equivalent creditor status.
- Reaching funding targets: having agreed an appropriate funding target, trustees should agree funding to eliminate any deficit over an appropriate period.
How this affects you?
Once the DB Code comes into force, it will apply to all schemes with future valuation effective dates. However, tPR has said that it will take a ‘pragmatic approach’ to the extent to which a scheme has taken the DB Code into account, depending upon where they are in its funding cycle at the date the DB Code comes into force. It is therefore important to ensure that: (i) trustees are working openly and transparently with the sponsoring employer to gain a keen understanding of the risks to the scheme; (ii) pensions professionals are helping clients to understand, monitor and mitigate these risks; and (iii) employers are working with trustees to understand the risks to the scheme and ensure that the funding obligations are met, whilst still allowing the business to grow sustainably.