The Regulator has published a new Code of Practice on funding defined benefits to take account of its new statutory objective "to minimise any adverse impact on the sustainable growth of an employer", which following Parliamentary approval will replace the existing code in the coming months. Although not currently in force, the Regulator encourages all trustee boards to take the new Code into account as far as reasonable in any ongoing valuation process.
Subject to some differences upon which we comment below, the main messages follow those set out in the Regulator’s consultation document which was published last December (see our previous Speedbrief for more details)
Highlights of the new Code
In particular, the Code:
- recognises that a strong, ongoing employer alongside an appropriate funding plan is the best support for a well-governed scheme;
- recognises that trustees need to comply with their fiduciary duties and ensure that scheme benefits can be paid as they fall due, whilst employers need to run their businesses, grow them as appropriate and ensure that they are able to provide the pensions they have promised;
- provides that trustees should adopt an integrated approach to risk management across the key risk areas to funding; namely, employer covenant, investment and funding related risks; and
- has nine principles underpinning it, which include working collaboratively, managing risk, seeking balance with the sustainable growth of the employer and taking a proportionate approach according to the scheme’s size, complexity and risk.
Change of approach from consultation document
The new Code does contain a number of changes to the initial consultation document, which have the potential to affect how funding discussions between employers and trustees are conducted in the future.
The Code now provides that deficits should be paid off over an "appropriate period". This is a significant move from the previous position, which required deficits to be paid by the employer(s) as quickly as reasonably affordable. What is appropriate in practice will clearly be a scheme-specific matter and determined by factors such as the employer’s plans for sustainable growth, risks within the scheme and the availability of other security for the scheme.
In terms of other themes running through the Code, the principle of "proportionality" is highlighted throughout and trustees are now being encouraged to "manage" rather than "mitigate" risk, by taking an integrated approach across the key risk areas of employer covenant, investment and funding risks.
In a change to terminology, the "balanced funding objective" which was previously consulted on is now referred to as the Funding Risk Indicator. Significantly, the Regulator has currently decided not to publish what these indicators are. This is likely to be in response to concerns expressed during the consultation that if such details were published, it could well result in a new "MFR".
Approach to Funding
In terms of the approach to funding, the Code confirms that:
- the trustees need to reflect the circumstances of both the scheme and the employer;
- trustees and employers need to work together in an open and transparent manner; and
- trustees (and their advisors) should manage conflicts of interest and duties properly.
The Code further states that the Regulator regards an adequate scheme funding solution as being one which is appropriate in the context of the employer’s covenant without an unacceptable level of investment risk.
Integrated Approach to Risk Management
Throughout the Code, there is an emphasis on ensuring an integrated approach to risk management is taken. In particular:
- trustees should adopt a proportionate integrated approach to risk management and understand what risks the scheme may face, be they employer covenant related, investment related or funding related;
- risk does not need to be eradicated completely and it is unnecessary for the employer to be able to cover all conceivable risks;
- tools used by trustees to understand risks should be proportionate to scheme and employer circumstances, remembering that pensions are deferred pay;
- the level of tolerable risk and flexibility adopted by trustees should be consistent with their key objective to pay the promised benefits; and
- trustees should ensure that they set appropriate contingency plans.
As has always been the case, the issue of employer covenant is critical to the approach to funding. In this regard, the Code confirms that:
- trustees should understand the employer covenant, including the employer’s ability to cope with downside outcomes;
- understanding the employer’s covenant should help trustees decide how much risk is appropriate and enable them to explore with the employer how prudent funding plans can be supported by, and balanced with, minimising adverse impact on the employer’s sustainable growth;
- covenant assessments should primarily be short- to medium-term, as longer-term assessment will be less precise;
- trustees should recognise that employers often need to invest in their businesses to enable them to grow and/or fulfil their obligations; and
- trustees should regularly and proportionately monitor employer covenant.
In terms of the investment limb to the integrated approach to funding set out in the Code, the Regulator confirms that:
- trustees should satisfy themselves that their investment strategy is consistent with their funding objectives, their risk appetite, the scheme’s liquidity needs and the trustees’ assessment of employer covenant;
- trustees should always engage with the employer to develop and implement an investment strategy, as its volatility could potentially impact upon the employer’s balance sheet and profit and loss; and
- trustees should pay more attention to the identification of risk, expected reward and appropriate asset allocation than to investment manager selection and monitoring.
In addition to providing a useful summary of the funding provisions of the Pensions Act 2004 (and Regulations made under it), the Code provides:
- deficits should be paid off over an appropriate period. This is a notable change from the approach to date, under which trustees have been required to seek payment of the deficit as soon as the employer can reasonably afford;
- trustees should seek a funding outcome that reflects a reasonable balance between the need to pay promised benefits and minimising any adverse impact on employers’ sustainable growth;
- technical provisions should not be weakened to make a recovery plan affordable; and
- recognition of the benefit to employers of agreeing contributions over a period of time to allow them to budget accordingly.
Employers and trustees should welcome the focus on balance, flexibility and proportionality which is delivered by this new Code. The need to adopt an integrated approach to risk management in respect of employer covenant, investment and funding is stressed throughout, which should support the approach already being taken by many schemes.
It is likely that the provisions in the Code which now provide for the deficit to be recovered over an "appropriate period" and for trustees to work with employers to reach solutions which also recognise the employer’s plans for sustainable growth will lead to interesting discussions during the valuation process. Hopefully, however, the Code will pave the way for openness and transparency and so enable trustees and employers to agree together the level of risk they are willing to take, bearing in mind the employer’s ability to address adverse outcomes.
Finally, as the Regulator has promised that it will be operating a comprehensive implementation programme, we would hope this will lead to consistent treatment for all schemes.