In December 2013 the Pensions Regulator (tPR) instigated a consultation on its draft revised code of practice on defined benefit (DB) scheme funding, its revised DB funding policy and its new DB regulatory strategy. This followed the issuing of revised guidance on asset-backed funding arrangements in November 2013.
We take time here to consider what implications the revised guidance will have for employers and trustees.
The current code of practice on DB scheme funding was introduced in 2006 as guidance to support the scheme-specific funding regime which came into effect at the end of 2005. Since then the funding landscape has changed dramatically, with more innovative solutions designed to free up working capital for employers becoming increasingly prevalent in a reaction to challenging economic conditions.
The Pensions Bill 2013 specifically acknowledges this through the introduction of a new statutory objective for tPR “to minimise any adverse impact on the sustainable growth of an employer” in the context of DB scheme funding.
The changes to the code of practice are primarily designed to reflect this new statutory objective, with a balance being struck between the funding requirements of pension schemes and the commercial needs of their sponsoring employers. The revised code has also been updated to reflect tPR’s experience over the last eight years.
The new code of practice is due to come into force by July 2014 and will apply to all schemes undertaking valuations after that date. Trustees and employers of DB schemes are, however, expected to bear in mind the requirements of the new draft code even where they are completing valuations in the first half of 2014. Additionally, the new funding policy is intended to apply to recovery plans submitted after the 2014 annual funding statement (which is expected in Spring 2014).
A revised code of practice: new funding principles
The new draft code of practice focuses on scheme funding principles for trustees to follow, unlike the existing code which deals mainly with the process of completing a valuation within the 15-month deadline.
Many of these guiding principles will already be at the forefront of trustees’ deliberations with employers as part of the valuation process. It is, however, the first time these have been codified by tPR and provides a valuable insight into tPR’s thinking on how trustees should approach a valuation. There are nine guiding principles:
- Balancing the needs of the scheme with those of the employer – TPR rightly views a strong ongoing employer with an appropriate funding plan as the best support for a scheme.
Trustees are, however, encouraged to form an assessment of the employer’s position and plans (including those for sustainable growth) and where appropriate to be prepared to use the flexibilities in the funding system (for example, in the setting of the discount rate or deciding on the length and structure of the recovery plan) to reflect the employer’s circumstances without compromising the correct outcomes for the scheme. The trustees’ assessment of the employer covenant will be key in this process.
- Managing risk – Trustees should take an integrated approach to risk management by considering employer covenant, investment and funding risks together.
- Reaching funding targets – Deficits should be eliminated as quickly as the employer can reasonably afford, but trustees should ensure that their decisions do not unreasonably impact on the employer’s sustained growth and long term ability to support the scheme, compromise the needs of the scheme or involve unnecessary risk taking.
- Working collaboratively – Trustees and employers should work together in an open and transparent manner to reach balanced funding solutions. • Proportionality – Trustees should act proportionately (taking into account the scheme’s size, complexity and employer covenant) in carrying out their functions.
- Taking risks – Where trustees take funding or investment risks, they should be confident that the employer is able to mitigate the 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 the employer covenant and funding and investment targets.
- Good governance – Trustees should adopt good governance standards.
- Fair treatment – Trustees should seek to ensure that the scheme is treated fairly amongst competing demands on the employer in a manner which is consistent with its equivalent creditor status.
A revised funding policy and new regulatory strategy
The revised funding policy stresses that tPR will interpret its new sustainable growth objective broadly, acknowledging that growth can mean different things to different businesses.
TPR will target its interventions at those schemes that pose the greatest risks and where it believes it can have the most impact. Under the proposals, schemes will be split into four broad categories, based on the strength of the employer covenant, ranging from strong to weak. The funding policy sets out the key characteristics for each category,
with the schemes with weaker employers being targeted for intervention.
The existing triggers which are used to determine whether a valuation should be investigated in more detail will be replaced with the “Balanced Funding Outcome”, which tPR will use to assess risk, taking account of the strength of the employer covenant and the maturity of the scheme.
TPR’s views on ABF arrangements
Asset-backed funding (ABF) arrangements, where the sponsoring employer of a pension scheme transfers assets into a special purpose vehicle which uses those assets to generate an income stream for the pension scheme, are proving attractive alternatives to cash contributions for a number of employers.
In its recent guidance published in November 2013, tPR acknowledges that such arrangements can improve an employer’s covenant to the pension scheme, as well as improving “a scheme’s security by providing access to valuable assets which were previously out of reach.”
The guidance does, however, balance this with a reminder that both employers and trustees should take appropriate steps and advice to mitigate the risks inherent with such arrangements, including:
- assessing and monitoring the risk of payment default by the sponsoring employer and/or the special purpose vehicle when comparing an ABF to a traditional direct cash contribution recovery plan;
- continuing to seek to reduce the funding deficit as quickly as the employer can reasonably afford, assessing how an ABF arrangement would compare to a traditional direct cash contribution recovery plan and considering whether entering into an ABF would fetter the trustees’ future funding negotiations;
- ensuring that the value of the underlying asset is adequate to support the payments promised;
- ensuring that the trustees are able to enforce their rights under the special purpose vehicle to access the value of the underlying asset in appropriate circumstances;
- taking specialist legal advice on whether restrictions on employer- related investments would apply and ensuring that appropriate mechanisms are built into the agreements underpinning the special purpose vehicle to manage the risk of the law changing (including building in an underpin to funding arrangements in case of this eventuality); and
- informing members of the ABF arrangement in a clear and transparent manner.
Some closing thoughts...
TPR’s revised guidance is clearly designed to give both trustees and employers a degree of flexibility.
In our view employers are likely to embrace this extra flexibility by bringing a longer term business view to the negotiating table. The challenge (as it has always been) for trustees will be to balance, on the one hand, the employer’s calls for structuring recovery plans with its own sustained growth in mind, with the need to ensure that the recovery plan is appropriate for the scheme and in members’ best interests.