15: Regulator consults on twin track DB funding regime
On 3 March 2020 the Pensions Regulator published the first of two consultation papers on a revised Defined Benefit (DB) funding regime. This first consultation sets out the new regulatory framework, the eight principles underlying the framework and guidance on how they could be applied in practice. The second consultation is planned for later in 2020 and will focus on the draft DB funding code itself.
Under the new regime, trustees will be able to choose either a ‘fast track’ or a ‘bespoke’ approach to their DB funding. Under the fast track approach, trustees will need to demonstrate compliance by reference to the eight principles set out in the consultation. If the bespoke approach is followed, trustees must demonstrate that it is appropriate to deviate from the eight principles in their circumstance.
The eight principles
- Demonstrating compliance and objective risk-taking: trustees must demonstrate they have thought through funding and investment risks and objectively evidence that these risks are remote or minimal or how they will otherwise be properly managed. Trustees must compare these risks against a tolerated risk position (which is likely to be the fast track parameters) and demonstrate the mitigation that supports the deviation from that position.
- Long-term objective: trustees will also need to set a long term funding objective so that when their scheme is ‘significantly mature’, the scheme has a low employer dependency and assets are invested with high resilience to risk.
- Journey plan and technical provisions: the Regulator will also require trustees to develop a journey plan to achieve the long-term objective. Technical provisions should have a clear and explicit link to the long-term objective and the two should converge over time, as evidenced by the journey plan.
- Scheme investments: the investment strategy and asset allocation should be broadly aligned with the scheme’s funding strategy while also having sufficient security and quality to satisfy liquidity requirements based on expected (and to some extent unexpected) cash flows. Asset allocation at ‘significant maturity’ is expected to have a high resilience to risk, a high level of liquidity and a high average credit quality.
- Reliance on the employer covenant and covenant visibility: Schemes with stronger employer covenants can take more risk (and assume higher returns in their technical provisions). However, the Regulator proposes limits on reliance based on covenant visibility, which the Regulator thinks does not typically extend beyond three to five years.
- Reliance on additional support: for the bespoke approach, trustees can account for additional support (such as contingent assets and guarantees) in their scheme valuations provided that support is sufficient to cover the risk being run and is appropriately valued, is legally enforceable and realisable at its necessary value when required.
- Appropriate recovery plan: Technical provision deficits should be recovered as soon as affordability allows, while minimising any adverse impact on the sustainable growth of the employer.
- Open schemes: Members’ accrued benefits in open schemes should have the same level of security as members’ accrued benefits in closed schemes.
Where schemes fail to meet the fast track principles, or choose not to, they can adopt a bespoke approach to their DB funding. Bespoke permits trustees to operate outside of some of the eight fast track principles but they must demonstrate that it is appropriate in their circumstance to do so. The Regulator will expect trustees adopting the bespoke approach to provide robust evidence to demonstrate compliance with relevant legislation, the extent to which they have deviated from fast track and how additional risk is being managed.
The Regulator notes that some schemes may be so stressed that they will not be compliant with the new regime but acknowledges where no additional funds are available, it will not be appropriate to exercise its enforcement powers. It will however help the Regulator establish the extent of such schemes and to develop other solutions.
In due course the Regulator will set a series of objective and quantitative compliance guidelines and parameters for the fast track approach. This will include some scheme specific factors such as maturity and employer covenant strength.
This will be key in determining how the new regime works and its impact on schemes, not least because, while there is flexibility built into the new regime, it is likely that many smaller schemes will seek to follow fast track. It will also mark the starting point for schemes following the bespoke approach.
In setting those fast track parameters the Regulator must balance the protection of pension savers without being so prescriptive that it encourages the use of the bespoke approach as the default.
The Regulator states that the proposed framework is consistent with many of the core principles from the current DB code and so does not expect the regime to be too onerous for schemes. However, the commitment to see recovery plans cut and the focus on improved and robust funding levels and a move away from employer covenant reliance could have an impact on sponsoring companies.
Importantly, the creation of the fast track approach effectively shifts the burden from the Regulator to trustees when it comes to demonstrating compliance. This will make it easier for the Regulator to bring regulatory action where trustees do not adopt fast track and fail to provide a convincing argument that their bespoke approach should be acceptable.
The consultation closes on 2 June 2020 and the responses will then be analysed before filtering through into any legislation which the DWP deems necessary. It is not anticipated that the new regime will be in place before the end of 2021.