10 key things you should know about the DB funding code consultation
March 03, 2020
The DB funding code consultation was published today and sets out more clearly than ever before what the Pensions Regulator (“TPR”) will expect from trustees and employers in terms of funding defined benefit pension scheme. Supported by changes in legislation and the introduction of the DB ‘Statement of Strategy’, the revised code will increase the transparency and accountability of the risks being taken on behalf of employers and members, with TPR having more scope to act when its expectations are not met. The code places a greater focus on schemes’ long-term strategy, reflecting the maturing DB pensions landscape.
We welcome this consultation and the clarity it provides on TPR’s thinking. It extends to more than 175 pages and is technical in nature - we set out below the 10 key things you should know.
1. Fast Track vs. Bespoke
The revised code proposes a twin track approach to demonstrating funding compliance, assessed by a range of quantitative tests which will vary by covenant and scheme maturity. Passing the tests is likely to lead to limited TPR scrutiny of the valuation (“Fast Track”). The alternative (“Bespoke”) route will allow more flexibility but places the onus on trustees to explain and evidence how and why their approach differs from fast track, as well as their approach to managing and mitigating any additional risks. This will be done in the ‘statement of strategy’.
The Fast Track framework is likely to become the starting point for future valuations especially for Trustees. Corporate sponsors may have reservations about the associated lack of flexibility under Fast Track, even if the Bespoke route involves a higher degree of analysis and supporting evidence. The illustrative examples of potential Bespoke scenarios provided by TPR are encouraging as they show that TPR will allow innovation, provided relevant risks are adequately addressed.
2. Long term objective (LTO)
Schemes should progressively reduce risk and reliance on covenant over time, and reach a position of ‘low dependency’ on covenant by the time they are ‘significantly mature’. TPR is consulting on the funding basis at ‘low dependency’ with the key assumptions including a discount rate (proposed to be somewhere in the range of Gilts + 0.25% pa to Gilts + 0.5% pa), as well as the relevant measure of maturity (with schemes being considered mature when their liability duration is in the range of 12 to 14 years).
LTO is a concept that has been discussed for some time, particularly among larger and mid-sized schemes, although the focus on scheme maturity as a key parameter may be new for some (our own work in this area shows that this is a nuanced area that requires careful consideration and modelling due to the impact on investment strategy and behaviours). The key implication of the consultation is that TPR has now put forward specific parameters considered appropriate under the Fast Track approach and it will be interesting to see the extent to which these start to shape future discussions. The Bespoke approach appears to offer flexibility in the level of the LTO, provided this is backed by an appropriate and robust investment strategy and additional support is granted to the scheme.
3. Journey Plan
Schemes should reduce risk over time and journey plans should provide a clear and explicit link between LTOs and TPs (as milestones to achieving LTOs). TPR acknowledges different types of de-risking journey plans as well as these will have implications on valuation discount rate methodologies (with some of the emerging discount rate methodologies considered to align most closely to the new principles).
Many schemes will need to review the details of their approach, including the link between their LTOs and TPs, and may need to make some revision to their approaches. Our experience developing asset-led discount rate methodologies with clients shows that these can bring greater clarity than the traditional single and dual discount rate approaches, particularly when it comes to measuring and managing risk effectively.
4. Technical Provisions (TP)
TPR envisages setting acceptable TPs for Fast Track as a maturity and covenant-linked matrix of ranges expressed as either the acceptable (i) discount rates or (ii) TPs expressed as percentage of the low-dependency funding measure.
The basic principle is that the greater the strength of employer covenant or other external support, or the more immature the scheme, the more risk can be assumed in the TPs. Some schemes will simply want to understand whether and how their current approach differs from Fast Track. But we would expect that many others will want to develop an approach which meets the principles in the code and reflects their own specific circumstances, then assess whether they meet Fast Track or need to evidence their approach under the Bespoke track.
Schemes with stronger covenants can take more risk and assume higher investment returns but trustees should reduce reliance on the covenant over time, with reliance under Fast Track limited to what TPR consider the period a typical covenant is visible (eg three to five years). TPR is also going somewhat to the first principles by consulting on the approach to assessing covenant, including retaining the current ‘holistic’ approach, or boiling covenant down into a more simple affordability metric.
Covenant assessment is an area of subjectivity for trustees under the Fast Track framework, and the holistic approach is likely to better reflect the full range of covenant indicators in most scenarios (including legal access to value, asset quality, competing creditors and the outlook for the employer’s markets). The focus on covenant visibility is likely to lead to a greater emphasis on the forecast performance of corporate sponsors, sensitivities and contingency planning and we expect this to be a key driver for corporates & trustees taking a ‘Bespoke’ approach. It is also likely to drive the adoption of additional security structures, which the sponsor may get more credit for, to support schemes while they continue to take appropriate risks.
6. Recovery Plans (‘RP’) and impact on dividends
TPR’s basic premise is that RPs should be as short as employer affordability allows, provided doing so does not impede employer’s sustainable growth. Views are being sought on the key elements of an appropriate RP for Fast Track compliance including its length, structure, allowance for asset outperformance and rules around the re-spreading of deficit at subsequent valuations. TPR makes cautious proposals on each of these factors. Equitability of treatment features highly too with TPR specifically mentioning the relationship between deficit recovery contributions (DRCs) and “value leakage” payments including dividends, intercompany loans and material management bonuses.
We expect to see schemes falling outside of the Fast Track parameters on RPs (eg RPs longer than six years) needing to be prepared to justify and evidence their approach, including the equitability of treatment between dividends and DRCs. TPR is seeking to make it easier to use its funding powers where employers are paying large dividends relative to DRCs, but we expect that there will still be a high degree of subjectivity in this area and the consultation signals that it will not be a one-size-fits-all approach. Where the RP is being lengthened due to a sponsor having alternative uses for its cash, TPR expects the trustees to consider whether additional support can be provided to the scheme.
7. Additional support (contingent assets and guarantees)
The Code encourages the use of additional support assets in funding solutions, but they won’t be covered by Fast Track. The consultation focuses on the role of contingent assets (eg seen as appropriate for underpinning longer-term risks) and guarantees (eg seen as appropriate for underpinning higher investment risk in the short term). Where these are used, TPR will expect trustees to follow a defined framework designed to assess the quantum and the quality of support actually provided, including understanding its impact if called upon.
Additional support assets represent an opportunity for trustees and sponsors to construct compliant Bespoke frameworks. We expect the code to increase the number of trustees and sponsors realising their value and recognising the place they have in relevant journey plans. Clients with existing PPF-compliant assets should consider what, if any, changes would be required to reflect an additional purpose and ensure appropriate credit is given for them in the new funding framework.
8. Investment strategy
TPR doesn’t propose to specify which asset allocation trustees should invest in at significant maturity - its focus is on the appropriate levels of investment risk that a scheme should take. Key parameters under consultation include how to measure the investment risk, its appropriate maximum levels and additional requirements around liquidity and quality of assets. Fast Track will involve a ‘pass or fail’ test and the Bespoke route will require articulation of key risks and evidence of how they will be supported.
Investments are an increasing area of focus at TPR. As trustees and sponsors come together to review their LTOs and journey plans it will be important for them to understand how the investment strategy needs to change over time and the level of risk being taken. As schemes continue to mature and move closer towards cashflow matching positions, stochastic Value at Risk models become less relevant compared with stress testing scenarios - it is encouraging to see this reflected in TPR’s consultation. Our work shows that a stress testing approach can look across scheme, sponsor and additional support as a whole, giving greater insights compared to traditional ‘scheme only’ VaR assessments.
9. Stressed schemes
TPR acknowledges that stressed schemes are one example of circumstances where the trustees and sponsors can’t agree a funding arrangement that meets Fast Track criteria. Such schemes often have very long RPs or take unsupported investment risk. For these schemes, TPR expresses the preference for an acceptable level of investment risk to be taken over a very long RP - contrasted with setting a short RP but taking higher levels of investment risk.
It is thought that there are around 700 schemes which are unlikely to ever be able to secure their benefits in full, but the consultation does not raise potential approaches to deal with schemes without viable RPs, such as benefit reduction. Application of the new code could shine a light on the fact that such schemes are unlikely to be able to meet the requirements of the LTO before scheme maturity means it’s too late. In practice, this may mean a move to consolidation or potentially accelerate insolvency events.
10. Open Schemes
TPR proposes that accrued benefits for members of open schemes should be as secure as they would be in a closed scheme. It is consulting on a range of options open to them within the new funding framework.
TPR is very clear that it does not intend the new code to create further pressure on open schemes to close. At the same time, it recognises that these schemes may mature much more slowly and potentially have investment strategies retaining return-seeking assets for longer. The need to comply with the new funding framework is likely to highlight the increasing costs of future accrual, as we’ve seen recently in the public sector.
What happens next?
The consultation will be open for 3 months until 2 June 2020. We recognise that many of our clients will have strong views which they will wish to contribute in answer to some or all of the questions raised by TPR.
It’s currently anticipated that the new code and associated legislation will come into force at the end of 2021 and many of the features under discussion may yet change in this period. Whilst it may be premature to make fundamental changes in response to a consultation, the direction of travel does seem to be fairly clear and both trustees and sponsors will want to consider how they may need to respond, without losing sight of the overall need to continue to manage their scheme in a way that best meets their specific circumstances.
Your key PwC contacts:
Funding - Jeremy May, +44 (0)7976 708256
Funding - Steven Dicker, +44 (0)7740 242783
Funding - Raj Mody, +44 (0)7974 969320
Covenant - Katie Lightstone, +44 (0)7850 907998
Covenant - Stephen Soper, +44 (0)7885 403139
Covenant - Jonathon Land, +44 (0)7879 411796
Investment - Adam Lane, +44 (0)7561 788 978
Legal - Oliver Reece, +44 (0)7920 847 211