The Pensions Regulator has issued a consultation paper setting out details of its new approach for the funding and risk management of DB schemes.

The consultation confirms how the Regulator intends to balance its new objective to minimise any adverse impact on the sustainable growth of employers with its existing DB funding objectives (please see our earlier article “Scheme funding takes another turn” published on 7 November 2013 for further details) and reflects how the Regulator’s approach to DB funding has evolved over the last eight years in light of its experience, and that of the pensions sector, in managing the risks in DB schemes. 

The consultation includes a draft revised funding code of practice, draft regulatory strategy for DB schemes and draft funding policy setting out the detail of the Regulator’s intended approach to DB funding issues.

Regulatory approach to DB funding

The draft DB regulatory strategy and DB funding policy set out the Regulator’s approach to DB schemes.  It abandons previous triggers and moves towards a more principles based regulatory approach, focusing on employer covenant, funding and investment strategy, and scheme governance. 

Segmenting the DB landscape

The Regulator has confirmed that it will target schemes that pose the greatest risk and where it believes it can have the most impact.  To allow targeted intervention, the Regulator will segment the DB landscape on the basis of employer covenant and will use four broad categories, ranking employers from “strong” to “weak”.  The DB funding policy sets out the characteristics that employers falling within each category will display and highlights the key issues the Regulator will be discussing with trustees and employers depending on where it rates the employer covenant.

Risk indicators and the “balanced funding outcome”

The Regulator will adopt a range of “risk indicators” which it believes will allow it to have a more rounded view of risks and scheme characteristics.  One of these risk indicators is the balanced funding outcome (BFO) that the Regulator will develop and apply to each scheme within each covenant segment to enable it to assess the level of risk associated with a scheme.

The BFO indicator does not set a minimum level of funding or contributions, but is a tool developed by the Regulator to provide a model for the characteristics of what a BFO for an individual scheme might look like.  It takes into account the strength of the covenant and the scheme's needs but does not take into account constraints on affordability.  The Regulator notes that this may mean that for some schemes and employers, the appropriate balance may be different to that indicated by the BFO.  The BFO will be reviewed annually to ensure that it remains flexible and capable of reflecting changing circumstances.

Other risk indicators include investment strategy risk, mortality, back-end loading, any reductions in contributions relative to existing recovery plan, avoidance issues, actions taken to weaken the covenant, PPF funding risk, reliance on investment outperformance in the recovery plan and governance.

The “risk bar”

The Regulator will select which schemes it will subject to further scrutiny by applying its risk bar for intervention.  When setting the risk bar, the Regulator will consider the scheme’s shortfall compared to the BFO indicator, the size of the scheme's liabilities, the potential impact of intervention and the overall resources it has available.

Key funding principles

The draft revised funding code of practice sets out nine key funding principles which the Regulator believes are universally applicable to DB schemes:

  • Working collaboratively: trustees and employers should 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 take an integrated approach to managing the key risks that influence a DB scheme’s chances of paying its benefits in full, namely funding, investment and employer covenant. 
  • Taking risk: where trustees take funding or investment risk, they should be confident that the employer is able to mitigate likely adverse outcomes over an appropriate period with appropriate contingency plans.
  • Taking a long-term view: trustees’ decisions should be consistent with their long-term views of employer covenant strength and funding and investment targets.
  • Proportionality: trustees should act proportionately, taking into account their scheme’s size, complexity and circumstances.
  • Balance: in discharging their duties and acting in the interests of members, trustees should consider the needs of the employer supporting the scheme.
  • Well governed: trustees should adopt good governance standards.
  • Fair treatment: trustees should ensure that the scheme is treated fairly among competing demands on the employer and in a manner consistent with its equivalent creditor status.
  • Reaching funding targets: trustees should aim for any funding shortfall to be eliminated as quickly as the employer can reasonably afford.

The consultation period runs to Friday 7 February and it is expected that the new funding code of practice will be in force by July 2014 and will apply to schemes undertaking valuations from that time.