A new code of practice for funding defined benefit pension

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A new code of practice for
funding defined benefit
pension schemes
In December 2013 the Pensions Regulator launched a consultation on the funding of defined
benefit (DB) pension schemes, which will run until 7 February 2014. The new regime is likely
to be in force from July 2014 and trustees currently undertaking valuations are encouraged to
bear in mind the key messages. A key driver for developing a new approach to DB regulation
is to take account of the new statutory objective ‘to minimise any adverse impact on the sustainable growth of an employer’. The consultation also 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.
Overview
The consultation contains drafts of:
– A revised code of practice on scheme funding that provides
practical guidance for trustees and
employers on how to comply with
the scheme funding requirements
– A new DB regulatory strategy
setting out at a high-level the
regulator’s risk-based approach to
tackling issues in DB pension
schemes, and
– A revised DB funding policy
describing in more detail the
regulator’s intended approach to
regulating DB funding.
At the heart of the consultation is
striking a balance between sponsoring
employers’ pension funding obligations
and their ability to invest for sustainable
business growth.
Code of Practice
The Code of Practice provides
practical guidance to help pension
trustees to meet the requirements of
scheme funding legislation. The code is
now more principle-based and
outcome-focused, to promote
flexibility and encourage best practice.
The new code should not come as
a surprise to trustees or advisors as
most of the contents are not new and
reflect previously stated principles, in
particular the 2013 Annual Funding
Statement.
Key funding principles
The revised code contains the following
key funding principles, which are
universally applicable to all schemes:
professional I proportionate
nTaking risk - Where trustees take funding or investment risk, they need to be confident that the
employer is able to mitigate possible adverse outcomes by way of
appropriate contingency plans.
nTaking a long-term view -Trustees’ decisions should be consistent with their long-term views of employer covenant strength and funding and investment targets.
nProportionality –Trustees should act proportionately in carrying out their functions given their scheme’s size, complexity and circumstances.
▲
nWorking 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.
nManaging risk -Trustees should integrate the management of employer covenant, investment and funding risks. They should identify, assess, monitor and mitigate those risks effectively – including setting clear triggers for action.
FUNDING DB PENSION SCHEMES
nBalance – Trustees must discharge their duties, and act in the interests of their members, but in doing so they will need to consider the needs of the employer supporting the scheme. They should ensure
that their decisions do not:
1. compromise the needs of the scheme; 2. unreasonably impact on the employer’s sustainable growth plans and its long term ability to
support the scheme, or 3. involve taking excessive or unnecessary risks.
Trustees should monitor key indicators
and take action when risks begin to
crystallise.
nWell governed – Trustees should adopt good governance standards.
Investment strategy
n How to determine the strategy
nHow to assess the risks
nMonitoring and ongoing management
nFair treatment – Trustees should seek to ensure that the scheme is treated fairly amongst competing demands on the employer in a
manner consistent with its equivalent creditor status.
The code goes on to set out some
details:
Employer covenant
nHow to assess covenant, the
minimum areas that need to be
addressed
nWhat is reasonably affordable to achieve sustainable growth
nContingency planning
Funding
n Assumptions and the level of
prudence in the discount rate
nRecovery Plans
nMaking decisions
nReaching funding targets – Having The linkage between employer
agreed an appropriate funding
covenant, investment strategy and
target, trustees should aim for any funding shortfall to be eliminated as funding assumptions is repeated many
times in the code. Investment risk
quickly as the employer can
should not be taken if the employer
reasonably afford.
would be unable to fund the
shortfall should the risk crystallise.
The regulator states that trustees and
employers should work collaboratively The regulator also provides an example of increased contributions where
and there should be no presumption
of a conflict of interest between them. the trustees had previously adopted an
unsuccessful risk strategy intended to
reduce employer contributions.
Integrated approach to risk
management
The code states that trustees should
adopt an integrated approach to
risk management when developing
a scheme funding solution. Trustees
should understand the risks and define
acceptable parameters for each of the
following inter-related areas:
The guidance on assessing investment
risk is more prescriptive than the
previous code of practice. Trustees
should understand the size and
likelihood of the risk, relative to the
employer’s ability to support it, by
considering future scenarios.
nEmployer covenant
nInvestment
nFunding
The code does not recognise that
small pension schemes are exempt
from annual actuarial reports and small
insured schemes are exempt from
preparing a statement of investment
principles. This may change in the final
documents but the new requirement
to monitor the covenant at least annually
seems unlikely to be weakened..
DB regulatory strategy
The DB regulatory strategy outlines the
regulator’s overall strategic objectives
and its approach to achieving those
objectives. It covers the principles and
objectives which underpin the regulator’s
approach to the regulation of DB
schemes and is therefore less directly
relevant to trustees and employers.
DB funding policy
The DB funding policy sets out the
regulator’s approach to regulating the
statutory funding requirements for
DB pension schemes. It sets out the
key objectives for DB funding: how to
assess risk,how to identify schemes that
require further engagement on their
valuations, how regulatory interventions are applied, and how to measure
the impact of any intervention.
Risk assessment
In developing an overall risk profile the
regulator will assess three key risks that
it expects trustees to manage as part
of good governance and an integrated
risk management process: employer
covenant, investment and funding.
▲
Covenant segments
The regulator proposes to segment
DB schemes on the basis of employer
covenant, as this is the key determinant
for trustee decisions. There will be four
employer covenant segments; strong,
tending to strong, tending to weak
and weak. The regulator’s definitions
of covenant are shown in the table
below. Placing schemes into segments
will allow the regulator to compare
individual schemes against characteristics
it expects to see and then judge its
position accordingly.
professional I proportionate
FUNDING DB PENSION SCHEMES
Balanced funding outcome
The regulator wants to encourage
trustees to balance the needs of the
scheme with those of the employer.
To do this, once schemes have been
segmented the regulator will apply a
“Balanced Funding Outcome” (BFO)
indicator to each scheme within each
covenant segment. The BFO will be
calculated as the level of contributions
required to achieve a self-sufficiency
funding level over the medium term.
The regulator will use a reference basis
for consistency, independent of the
scheme’s funding assumptions. The
BFO takes into account the strength of
the covenant and the scheme’s
maturity so that the regulator can
assess the level of risk associated with
a scheme. The prevailing economic
and investment market conditions will
also be factored into the BFO.
For example, the stronger the employer
covenant, the more acceptable it may
be for trustees to seek higher returns
through the investment strategy. In
comparison, the weaker the employer
covenant, the less acceptable it may be for
trustees to take significant investment risk.
Investment risk should not be
taken if the employer would
be unable to fund the shortfall
should the risk crystallise.
Risk bar
Scheme selection for intervention is
informed by a “risk bar”. The factors
the regulator will take into consideration
when setting the risk bar include:
nThe shortfall compared to the BFO indicator.
nThe size of the scheme’s liabilities.
nThe potential impact of intervention and the value the regulator can add through intervention.
nThe overall resources available
The regulator aims to target its interventions on those schemes which pose
the greatest risks and where it believes
it can have the most impact.
Covenant Definitions
nCovenant grade 1 (CG1) – Strong
Very strong trading, cash generation and asset position relative to the size of the scheme and the scheme’s deficits.
The employer has a strong market presence (or is a market leader) with good growth prospects for the employer and the market.The scheme has good access to trading and value if the employer is part of a wider group. Overall low risk of the employer not being able to support the scheme to the extent required in the short/medium-term.
nCovenant grade 2 (CG2) – Tending to strong
Good trading, cash generation and asset position relative to the size of the scheme and deficits. Operates in a market with a reasonably positive outlook and the employer has a stable market share. Outlook is generally positive but medium-term risk of employer not being able to support the scheme and manage its risks.
nCovenant grade 3 (CG3) – Tending to weak
Concerns over employer strength relative to the size of the scheme and deficits and/or signs of significant decline, weak profitability or balance sheet concerns and/or high vulnerability to economic cycle. No immediate concerns over
insolvency but potential risk of further decline
nCovenant grade 4 (CG4) – Weak
Employer is weak, to the degree that there are concerns over potential insolvency, or where the scheme is so large that, without fundamental change to the strength of the employer, it is unlikely ever to be in a position to adequately support the scheme.
professional I proportionate
FUNDING DB PENSION SCHEMES
How focus changes with
covenant strength
Next steps
The table below shows the
regulator’s initial focus when opening
an investigation into a scheme,
depending on covenant strength. It
highlights the key issues the regulator
will discuss with trustees and ask for
explanations behind their funding
decisions.
The closing date for responses to the
consultation is Friday 7 February 2014.
Final documents are expected to be
published in Spring 2014 and will apply
to schemes undertaking new valuations
from July 2014. The 2014 annual
funding statement will set out a BFO
indicator and risk bar for interventions
in respect of specific valuation dates.
Many schemes will feel that they
already comply with the regulator’s
newly-stated principles. However, once
the code has been finalised all schemes
will need to review their detailed
procedures. In particular, the
requirement to document an
integrated approach to covenant,
investment and funding will be new
for most.
Covenant Strength
Strong
Tending to strong
Tending to weak
Weak
Sustainable growth plans
Payments that weaken
covenant a concern
Keeping covenant strong
Scheme viability
a concern
Managed
solutions
Likely to be in a position to handle risk
Funding plan to reflect covenant risks
Maximise
covenant value
Risk taking needs significant management
Strong contributions or
security in place
Strong target needed reflecting investment
strategy and weak support for risks
Source: The Pensions Regulator
For more information please contact
your Xafinity consultant or alternatively,
Thomas Laws on
T: 0118 918 5280
E: [email protected]
The information contained in this article should not be relied upon for detailed advice
or taken as an authoritative statement of the law. Any decisions should be taken on
the advice of an appropriately qualified professional adviser.
Xafinity Consulting Limited. Registered Office: Xafinity House,42/62 Greyfriars Rd, Reading, RG1 1NN. Registered in England and Wales
under Company No. 2459442. Xafinity Consulting Limited is authorised and regulated by the Financial Conduct Authority for its investment
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