DB Test of strength

The Regulator’s latest code of practice introduces new objectives for assessing the strength of a scheme explains Jane Beverley, Punter Southall

In a nutshell: 
  • TPR’s new sustainable growth objective is the key driver for a new code of practice and may shift the balance of power towards the employer
  • the revised code also reflects developments in TPR’s scheme funding since 2006, in particular the introduction of an integrated approach to risk management
  • TPR will use a more sophisticated suite of risk indicators to decide when to intervene in funding decisions.

If we wind the clocks back to the launch of the Pensions Regulator (TPR) in April 2005, the talk was all about trustees being encouraged to negotiate robustly with the sponsoring employer. Many commentators saw the introduction of the scheme specific funding regime as a shift in the balance of power towards the trustees of pension schemes.

Contrast that with some of the wording in TPR’s recent consultation on a revised draft code of practice on defined benefit funding, such as “agreement may often be reached without the need for protracted negotiation” and there should be “no presumption of conflict between the scheme’s needs and those of the employer”. Is this a funding revolution?

Sustainable growth

One of the key drivers for the revision of the code of practice is the imposition of a new objective on TPR “to minimise any adverse impact on the sustainable growth of an employer” in the context of scheme funding.

The new objective was designed by government to address a perception that the needs of the employer were not being given sufficient prominence in scheme funding decisions.

The wording of the new objective itself is strong: taken to logical extremes, it suggests that TPR has to do everything it can to ensure that the employer’s sustainable growth is affected as little as possible by the requirement to fund the pension scheme.

While the sustainable growth objective technically applies to TPR, it was surely inevitable that it would be passed on to the trustees in practice and this is what the new draft code does. It is noticeable, however, that the draft code does not give trustees carte blanche to go along with any of the employer’s plans for sustainable growth; the emphasis is on allowing employers “to invest in the growth of their business so that they can provide long-term support to the scheme”. It is not a matter of sustainable growth for the employer at any cost to the scheme: investing in sustainable growth is intended to form part of a virtuous circle that improves the position of both scheme and employer.

Nor is the concept of sustainable growth fully defined. TPR notes that sustainable growth will have different meanings for different employers, depending on the employer’s position in the business cycle or the sector in which it operates. Growth for a business that is trying to invest to slow down a decline in its profits or growth for a not for profit organisation will mean something very different from the normal meaning of the word “growth”.

It seems likely that the force of the new objective will come down not to the wording of the objective itself, nor even to the relevant sections in the code of practice, but to the actual perceptions of trustees and employers.

Some trustees may fear that the new objective gives employers a “Get out of jail free” card in funding negotiations: all the employer needs to say is “sustainable growth” and the trustees will have to let employers off the hook.

Other trustees may see this as simply an extension of discussions they are already having with their employer. The new objective is therefore likely to continue to lead to scheme specific funding decisions.

Co-operation

One of the key themes in the revised code of practice is a focus on trustees and employers working together collaboratively. Indeed, one might feel that TPR goes a little too far in its enthusiasm for co-operation: while it is certainly true that some trustees and employers will be able to reach agreement without protracted negotiation, is it likely to often be the case?

There is, however, much to welcome in the emphasis on trustees and employers engaging early and often in funding discussions and being open and transparent in their dealings with each other. No matter how protracted the negotiations may be, a willingness to work together is likely to make those discussions easier.

TPR intends to introduce a “balanced funding outcome” indicator against which schemes will be measured, taking account of the strength of their covenant and the maturity of the scheme.
Jane Beverley

New focus

While the new objective may have been the immediate trigger for TPR to review its code of practice, it also gives TPR the opportunity to reflect changes in its approach to regulating defined benefit schemes over the nearly eight years since the code first came into force in February 2006. Nowhere is this more evident than in its focus on integrated risk management.

The original code contained fewer than ten references to the employer covenant and fewer than 20 to investment. The emphasis was on the valuation process itself and the selection of prudent assumptions for technical provisions.

The revised code is radically different with funding risk now only one of three key risks in scheme funding decision making, alongside covenant related risk and investment risk, with covenant and investment now mentioned over 200 times in the draft revised code.
While the underlying scheme funding legislation has a good deal to say on the setting of funding assumptions and the valuation of technical provisions, it is silent on the role of both the employer covenant and investment strategy in scheme funding decisions. The focus on all three risks and the advice to consider them as part of an integrated risk management framework is a development that derives wholly from TPR’s regulatory approach. While the employer covenant has been part of TPR’s approach since the early days of scheme funding (with detailed guidance on the covenant appearing in 2010), it has only been in recent years that TPR has started to talk about the importance of integrating investment strategy into funding decisions.

Falling short

As part of its recent consultation, TPR explained that it was abandoning its old triggers for regulatory intervention and replacing them with a suite of risk indicators.

The move away from the triggers is not surprising; and it could be argued that the clustering of recovery plans around the ten year trigger undermined the principle of having a scheme specific approach to funding.

At the heart of its new suite of risk indicators, TPR intends to introduce a “balanced funding outcome” (BFO) indicator against which schemes will be measured, taking account of the strength of their covenant and the maturity of the scheme.

The extent to which the scheme falls short of the BFO will be the key factor governing the likelihood of regulatory intervention. While the consultation contains some information on how this BFO indicator will be derived, it is not completely clear. One senses that TPR is torn between on the one hand wishing to avoid creating a new trigger that schemes may try to predict and target and on the other wishing to be open and transparent.

The BFO indicator is, however, only one of the tools that TPR will use to decide whether to intervene. It has said explicitly that, given its limited resources, it will focus its attention on larger schemes and it will also look at factors such as investment strategy risk, back-end loading in deficit reduction contributions and evidence of poor scheme governance.

TPR acknowledges that it needs to ensure a consistency of approach from its case teams in deciding when and how to intervene.

Evolution or revolution?

In some ways, the new code of practice reflects natural developments in TPR’s approach over the years since the scheme funding regime was introduced. It is an evolution from a process designed to implement the Pensions Act 2004 legislative framework for scheme funding towards an approach that takes into account the practical experience of trustees, employers, advisers and TPR itself as to what are the real risks to be identified and managed and the real decisions to be taken as part of the scheme funding process.

Yet when you compare the new code of practice with its previous version, it is the word “revolution” rather than “evolution” that comes to mind. Trustees and employers, formerly seated on opposite sides of the table, are now encouraged to work together and employers have been given the potential trump card of “sustainable growth” to strengthen their hand.
The emphasis is now not so much on the ability of trustees to negotiate robustly with employers as on the robustness of the scheme to withstand shocks and the risk management framework that is put in place to achieve this.

The revised code is expected to be laid before Parliament in May 2014, but it is likely to be some time before we can see how significant the funding revolution is in practice.

Jane Beverley is head of research at Punter Southall.

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